Indian Rupee hits all-time low against the dollar – CBS News

A couple of years ago I wrote what I would call a “fantasy” blog post about how the recent depreciation of the British pound would have made a ski trip to India a whole lot cheaper since the tour company I was planning to go with quoted its prices in the British currency. Well, at the time I wasn’t really planning to go skiing in the Himalayas, but this year, because of a fall in the value of another currency, I really AM going to ski in the Himalayas!

The chart below shows how the value of the Swiss franc has changed against the Indian rupee over the last year and a half.

The Value of the Swiss Franc in terms of India Rupees – last 18 months

As can be seen, the franc, which is the currency in which I get paid here in Switzerland, has risen from only 40 rupees 18 months ago to as high as 63 rupees in August this year, and is currently at 57 rupees per Swiss franc. We’ll explore the underlying causes of this appreciation of the franc in a moment, but first let’s examine its effect on my dream of skiing in the Himalayas.

So just yesterday morning I did, at last, after six years of dreaming of this adventure, book a six day guided ski trip in the Indian Kashmir town of Gulmarg, which sits at an elevation of 2800 meters and has lift-accessed skiing up to 4,000 meters, making Gulmarg the second highest ski resort in the world. Okay, enough facts. The strong franc made this trip a reality for me for the following reason:

• 18 months ago, the 40,000 rupee price tag of this ski trip would have meant a cost of 1,000 swiss francs.
• Today, due to the strong franc, the 40,000 rupee price tag means this trip is only costing me 700 swiss francs.

courtesy: http://www.gulmargpowderguides.com/

Related posts:

1. Stability – the greatest Swiss virtue?
2. The joys and sorrows of the strong Swiss franc
3. The Great Wealth of China: Shaping the World Economy

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
• Economic growth

source: http://www.beaumontenterprise.com/

 

Related posts:

1. The battle of ideas: Hayek versus Keynes on Aggregate Supply
2. Too much debt or not enough demand? A summary of the debate over America’s fiscal future
3. Keynesian/Classical debate enters the realm of hip hop

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.

Related posts:

1. The almighty bond market: Niall Ferguson’s concerns about the US deficit explained
2. A closer look at the crowding-out effect
3. Economics in plain English: Understanding Argentina’s budget woes

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?

Related posts:

1. McCain and the Republicans: fiscal conservatives? Think again…
2. The U.S. National Debt: How Bad is the Problem?
3. Fiscal Stimulus package passes in Congress – here comes $170 billion, America!

I received the following email today, which gave me a great excuse to write a blog post about monetary policy! My reply to the teacher is below.

Jason,

I hate to bug you, but I have a question. I am a first year AP Econ teacher and I know something is going to come up right away and I want to explain it in the simplest way. “Why can’t the govt. just print more money?” I know the inflation part of it, but when I am reading to look for quality ways of explaining it, I see plenty of information about it, but I can’t grasp it. Principle 9 in Mankiw text states “Prices rise when the govt. prints too much money.” I feel like a dumb kid and I am supposed to teach this!!!!

If you can help, great, if not, I will figure it out.

Thanks,
Teacher

Dear Teacher,

I love your question! It is definitely one of those issues that gets glossed over in most economics textbooks. Or it is assumed that the money supply diagram makes it obvious why excessive monetary growth leads to inflation. But I agree, this is one of those things that for the first couple of years I taught economics, I probably didn’t really understand all that well either! So let me try to break it down in plain English for you. This will be good for me too, cause I always understand things more clearly myself after writing them (which is why writing a textbook is about the best PD I’ve every undertaken!)

So, here it goes:

Printing money and its effect on inflation is a bit more complicated than it sounds. In fact, it is the US treasury that prints money, but it is the Federal Reserve that determines how much money is actually in circulation in the economy. Money printed by the Treasury is distributed to the twelve Federal Reserve banks around the country. The treasury and the government of which it is a part does not have any say on how much money actually gets injected into the economy, as monetary policy decisions are left up to the Federal Reserve.

Traditionally, the Fed has one tool for injecting new money into the economy, a tool known as “open market operations”. (I say traditionally, because in the last three years the Fed has devised numerous new ways to “inject liquidity” into the economy, which I will not get into now). To increase the nation’s money supply, the Fed buys US government bonds on the open market from commercial banks. Commercial banks invest some of American households’ savings into government bonds just like they invest some of our money into individuals and businesses by making loans and charging interest on those loans. Commercial banks will want to buy government bonds if the interest on them rises and will want to sell those bonds when the interest rate falls.

If the Fed want to increase the money supply to stimulate spending in the economy, it will announce an open market purchase of bonds. When the Fed buys bonds, the demand for bonds increases, raising their prices and lowering their effective interest rate. As the interest on government bonds falls as a result of the Fed’s open market operations, banks find them less desirable to hold onto as investments and therefore sell them to the Fed in exchange for, you guessed it, liquid money, fresh off the printing presses!

Remember, the money printed at the Treasury and held at the Fed was NOT part of the money supply, since it is out of reach of private borrowers. But as soon as the Fed buys bonds with that money, it is deposited into commercial banks’ excess reserves and is therefore now in the commercial banking system and therefore part of the money supply. So, “printing money” does not immediately increase the money supply since newly printed money only ends up in the Fed; only once the Fed has undertaken an expansionary monetary policy (an open market bond purchase) does the newly printed money enter the money supply.

Now, commercial banks have just sold their illiquid assets (government bonds) to the Fed in exchange for liquid money. Picture the money market diagram and you will see the money supply increasing.

So the next question is, why does this lead to inflation?

Banks now hold more excess reserves, most of which are kept on reserve at their regional Federal Reserve bank. Reserves held at the Fed do NOT earn interest for the banks, and therefore actually lose value over time as inflation erodes the purchasing power of these idle reserves. Banks, of course, want to invest these reserves to earn interest beyond the rate of inflation and thereby create earn them revenue. In order to attract new borrowers, commercial banks, whose reserves have increased following the Fed’s bond purchase, must offer borrowers a lower interest rate. The increase in the supply of money leads to a decrease in the “price” of money, i.e. the interest rates banks charge borrowers.

So here we see why an increase in the money supply leads to lower interest rates. With greater excess reserves, banks must lower the rate they charge each other (the federal funds rate) and thus the prime rate they charge their most credit-worthy borrowers and all other interest rates in the economy, in order to attract new borrowers and get their idle reserves out there earning interest for the bank.

Lower interest rates create an incentive for firms to invest in new capital since now more investment projects have an expected rate of return equal to or greater than the new lower interest rate. Additionally, the lower rates on savings discourages savings by households and thereby increases the level of household consumption. Households find it cheaper to borrow money to purchase durable goods like cars and it also becomes cheaper to buy new homes or undertake costly home improvements. So we begin to see investment and consumption rise across the economy as the increase in the money supply reduces borrowing costs and decreases the incentive to save. Aggregate demand has started to rise.

Additionally, the lower rate on US government bonds resulting from the Fed’s open market purchase reduces the incentive for foreign investors to save their money in US bonds and in US banks, which are now offering lower interest rates. Falling foreign demand for the dollar causes it to depreciate. A weaker dollar makes US exports more attractive to foreign consumers, so in addition to increased consumption and investment in the US, net exports begin to rise as well, further increasing aggregate demand.

Increasing the money supply (not so much by printing money rather because of the “easy money” policy of the Fed), leads to increased consumption, investment, and net exports, and therefore aggregate demand in the economy. The rising demand among domestic consumers, foreign consumers, and domestic producers for the nation’s output puts upward pressure on prices as the nation’s producers find it hard to keep up with the rising demand. Once consumers start to see prices rising, inflationary expectations will further increase the incentive to buy more now and save less, leading to even more household consumption. Firms see price rises in the future and increase their investment now to meet the expected rises in demand tomorrow.

It does not take much for inflation to accelerate in such an environment. If the the government and the Fed do not slow down the increase in the money supply (STOP THE PRINTING PRESSES!) then soon enough workers will begin demanding higher wages and resource costs will start to increase in all sectors of the economy, causing the nation’s aggregate supply to decline as firms find it harder to cover their rising costs. Now we have both demand-pull AND cost push inflation! The weaker currency also makes imported raw materials more costly to firms, further adding to the inflationary environment. An inflationary spiral is now underway!

Milton Friedman said that “inflation is always and everywhere a monetary phenomenon”. Controlling the rate of growth in the money supply, say the monetarists, will assure that the fluctuations in the business cycle will be mild and periods of dramatic inflation and deflation can be avoided. Stable money growth should lead to stable economic growth. But as soon as we start running the printing presses inflation will not be far behind. On the flip-side, contractionary monetary policies should in theory lead to the exact opposite of what I describe above and cause a deflation. If a central bank were to tighten the money supply too much, interest rates would rise, investment, consumption and net exports would fall, and falling prices would force firms to lay off workers, leading to high unemployment and an economic contraction.

I’ll leave you with one question to ponder (the answer to which would require a much longer article than this one!). If Friedman was right, and increasing the money supply will always and everywhere lead to inflation, then how is it that the monetary base in the United States increased by 142% between 2008 and 2009, yet inflation declined over the same period and fell to as low as -2% in mid-2009? That’s right, the money supply more than doubled, yet the economy went into deflation. Was Friedman missing something in his calculation that monetary growth always leads to price level increases? In other words, is an open market purchase of bonds by the Fed all that is needed to stimulate demand during a recession? Perhaps Friedman, who died in 2006 right before the US entered the Great Recession, would have to re-consider his famous quote if he could see the effect (or lack of effect) of America’s unprecedented monetary growth over the last three years!

Related posts:

1. From the Help Desk – more on loanable funds and the money market
2. Loanable Funds vs. Money Market: what’s the difference?
3. Will the Fed’s easy money policy fuel global inflation?

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.

Video 1 - Krugman argues for continued stimulus:

Click here to view the embedded video.

Discussion Questions:

1. What are the two “profoundly different views of economics” that are being tested as governments begin rolling back the fiscal stimulus packages of the last two years?
2. What are three characteristics of an economy in a “depression” according to Krugman?
3. What is “budget austerity” and why does Krugman think this should not be the first priority of policymakers in the G20 nations?
4. Why is deflation dangerous according to Krugman?
5. What is the additional annual cost to the US government of borrowing and spending an additional trillion dollars now? What is the potential additional benefit of more stimulus?

Video 2 - Ferguson argues for austerity and “fiscal regime change”:

Click here to view the embedded video.

Discussion Questions:

1. Why might the US have to pass spending cuts and tax increases to maintain its “credibility in international bond markets”?
2. Why would fiscal tightening “choke off the recovery”?
3. How is the financial crisis in Europe a warning to the US?
4. How could the “costs” exceed the “benefits” of deficit financed expansionary fiscal policy.
5. Ferguson proposes a new type of policy that “boosts confidence”. Why will expansionary fiscal and monetary policies fail if private sector confidence remains depressed?

Related posts:

1. Will the stimulus package “crowd-out” private investment and reduce long-run growth potential in America?
2. Obama’s stimulus is “the first real test of Keynesian economic policy”
3. How big is the government spending multiplier in America? Well, it depends on which economist you ask…

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!

Related posts:

1. Sample IB Economics Internal Assessment Commentary – Understanding the ECB’s bond-purchasing program
2. Unemployment and inflation: understanding the Fed’s balancing act
3. China’s “silver bullet” – a strong RMB could solve her biggest economic woes…

This article was originally posted on September 19, 2007

FT.com / Asia-Pacific / China – China freezes government-set prices

Here’s a great article for both AP and IB students to pay attention to. The Chinese government is responding to rising prices at home by resorting to some good old fashioned “iron fist” measures, namely price controls on a wide range of products. For the rest of this year, prices on certain goods and services will not be permitted to rise, OR ELSE! (what? we don’t want to know!)

China has begun to enforce a freeze on all government-controlled prices in a sign of the central government’s alarm about rising popular anger over inflation, now at the highest rate in over a decade.The order freezes a vast array of prices still under the control of governments in China, ranging from oil, electricity and water, to the cost of parking and park entrance fees.

I find the following statement interesting:

“Any unauthorised price rises are strictly forbidden…and in principle, there will be no new price-raising measures this year,” the ministries’ announcement said. (italics added)

How strange is it that the government’s announcement pointed out that the freeze on prices is only in principle? Could this be the government’s attempt to placate a public that’s grown angry at their weakening purchasing power? Does this mean that if prices actually do go up, the government can just say, “Hey, at least we tried!” Looks like the old communist mentality has softened a bit in the era of market reforms!

So what’s the source of all these rising prices? Well, food plays a big role, thanks to a couple of factors:

The sharp spike in inflation is largely due to higher food prices, because of a shortage of pigs after a disease killed millions late last year and earlier in 2007, and the rising cost of feed, a global
phenomenon.

The China of today is very different from that of 20 or 30 years ago, when the government played a much larger role in the economy. Unleashing the beast of the free market in the early 80′s may have meant the government would have to loosen its grip in situations such as today’s inflation, and let the free market adjust on its own.

Economists said the price freeze is the kind of administrative measure redolent of China’s former planned economy, but it may be less effective in China today.

“They will not be able to control the price of everything,” said Chen Xingdong, of BNP Parisbas in Beijing.

Perhaps that’s for the better.

Discussion Questions:

1. Why might the government’s price controls actually make the matter worse for the average Chinese?
2. If the government were to take a “laissez faire” approach to the problems faced by China, how might the free market resolve them on its own? Any ideas?

Related posts:

1. “A glimmer of hope” – rising incomes in China lead to rising demand for US exports
2. The true causes of and solutions to inflation in China
3. Deflation: why lower prices spell doom for any economy!

Economics focus: Much ado about multipliers | The Economist

What is the goal of fiscal stimulus during a recession? Is it simply to increase nation’s total income by a certain amount determined by how much a government increases its own spending by? If this were the case, then an $800 billion stimulus package, like the one begun this year in the US, would lead to a total increase in national income of, well, exactly $800 billion.

While such an outcome is possible, it is not the desired outcome of the Obama administration and the economists who have supported the use of expansionary fiscal policy during economic downturns (i.e. the Keynesian school of economists). Keynesians expect that an initial increase in government spending (or a decrease in taxes) will result in households and firms increasing their own consumption and investment, meaning successive increases in spending. The initial change in spending ultimately gets multiplied through further rounds of spending. The total change in national income resulting from an initial change in government spending or taxes depends on the size of the fiscal multiplier. Now, this is where things get tricky! From the Economist:

The size of the multiplier is bound to vary according to economic conditions. For an economy operating at full capacity, the fiscal multiplier should be zero. Since there are no spare resources, any increase in government demand would just replace spending elsewhere. But in a recession, when workers and factories lie idle, a fiscal boost can increase overall demand. And if the initial stimulus triggers a cascade of expenditure among consumers and businesses, the multiplier can be well above one.

The above scenario, where an economy is operating below full-employment and government spending puts the nation’s idle resources to work, creates new income and further increases private spending, is precisely what the Obama team and its economists hope will happen in the US economy soon. A multiplier of above one means the $800 billion will ultimately increase America’s national income by something greater than $800 billion!

The multiplier is also likely to vary according to the type of fiscal action. Government spending on building a bridge may have a bigger multiplier than a tax cut if consumers save a portion of their tax windfall. A tax cut targeted at poorer people may have a bigger impact on spending than one for the affluent, since poorer folk tend to spend a higher share of their income.

Crucially, the overall size of the fiscal multiplier also depends on how people react to higher government borrowing. If the government’s actions bolster confidence and revive animal spirits, the multiplier could rise as demand goes up and private investment is “crowded in”. But if interest rates climb in response to government borrowing then some private investment that would otherwise have occurred could get “crowded out”. And if consumers expect higher future taxes in order to finance new government borrowing, they could spend less today. All that would reduce the fiscal multiplier, potentially to below zero.

Herein lies the controversy about the effectiveness of deficit-financed fiscal stimulus. Several posts on this blog have focused on the neo-classical, supply-side economists’ fears that expansionary fiscal policy financed by government borrowing will drive up interest rates to private borrowers, thereby “crowding-out” private investment, off-setting any expansion in output achieved through government spending. In the Keynesian model, however, it is precisely because interest rates have bottomed out at the “zero bound” (according to Paul Krugman) that government borrowing and spending will not lead to crowding-out, rather could actually increase investors’ willingness to spend (their “animal spirits”) on new capital, actually “crowding-in” private investment.

Alas, the debate continues. The ironic thing is that even years from now, after all of Obama’s stimulus money has been spent, and the US economy is either fully recovered or it is not, we still won’t know how large the fiscal multiplier was, since tomorrow’s economists will find it nearly impossible to isolate the variable of the $800 billion of government spending and determine just how much of America’s growth in income can be attributed to government spending, and how much resulted from automatic stabilizers built-in to help the economy recover on its own during recessions.

Discussion Questions:

1. Why do tax cuts for the rich tend to have a smaller multiplier effect than tax cuts for lower income households?
2. How can government borrowing drive up interest rates, and why is this a concern to policy makers deciding on the size of a fiscal stimulus package?
3. What are the animal spirits the article mentions? Where have you heard this expression before?
4. Do you think borrowing trillions of dollars and spending it to put people back to work and try to dig the US economy out of recession is wise, or should the US government be practicing better fiscal responsibility?

Related posts:

1. The potency of government spending and taxation.
2. The Multiplier Effect as it applies to the Obama camp’s fiscal stimulus proposal
3. Too much debt or not enough demand? A summary of the debate over America’s fiscal future

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

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

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

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

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

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

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

Fareed Zakaria asks Ferguson:

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

Ferguson’s reply:

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

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

Ferguson:

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

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

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

Discussion Questions:

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

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

Related posts:

1. A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out
2. Sample IB Economics Internal Assessment Commentary – Understanding the ECB’s bond-purchasing program
3. “The Ascent of Money” – Economic historian Niall Ferguson on the Colbert Report

Liquidity preference, loanable funds, and Niall Ferguson (wonkish) – Paul Krugman Blog – NYTimes.com

Below is the loanable funds market at its current equilibrium, according to Krugman (I is investment demand for funds, S is the supply of loanable funds):

In Krugman’s words:

In effect, we have an incipient excess supply of savings even at a zero interest rate. And that’s our problem.

So what does government borrowing do? It gives some of those excess savings a place to go — and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending, at least not until the excess supply of savings has been sopped up, which is the same thing as saying not until the economy has escaped from the liquidity trap.

In AP Macroeconomics, we teach that deficit-financed government expenditure decreases the supply of loanable funds as savers take their money out of commercial banks and invest in the bond market due to the attractive interest rates on government debt. Less funds available for the private sector drives up interest rates and crowds out private investment.

If the economy is producing close to the full-employment level and interest rates are positive, the decrease in supply of loanable funds can indeed drive up equilibrium interest rates and lead to the “crowding-out” of private investment. Krugman points out in this article that when the economy is at the “zero-bound” (i.e. when nominal interest rates are as low as they can go) and the quantity supplied of savings is still greater than the quantity demanded for investment, the government can effectively borrow from the public, decreasing the supply and correcting the surplus of savings without driving up interest rates in the private market. Put another way, the equilibrium interest rate is below zero, but the “zero-bound” acts as a price floor in the loanable funds market, resulting in a surplus of savings.

Government borrowing crowding out private investment is not something we can worry about during a recession, when low confidence and expectations have driven the supply of savings up and the demand for investment down. Public spending will divert funds from the private sector to the public sector, that’s true. But in today’s case, savings are sitting idle in the private sector, so government borrowing is putting those fund to use when the private sector has failed to do so.

Discussion Questions:

1. Why does the supply of loanable funds (S in the graph above) slope upwards? Why does the demand for loanable funds (I in the graph) slope downwards?
2. Deficit financed government spending decreases the supply of loanable funds. Why?
3. Crowding-out is not the only possible down-side of deficit spending by the government. What are some other long-term effects of governments running budget deficits year after year?

Related posts:

1. A closer look at the crowding-out effect
2. How big is the government spending multiplier in America? Well, it depends on which economist you ask…
3. The almighty bond market: Niall Ferguson’s concerns about the US deficit explained

I love this discussion between John Stewart and former director of the National Economics Council Lawrence Lindsey. Stewart pitches his own version of a fiscal stimulus package to the economist, and is surprised when Lindsey agrees with the plan.

I find Lindsey’s suggestion that a stimulus package should include subsidized mortgage rates to home owners fascinating. According to Lindsey, a homeowner with a $200,000 mortgage paying 6% interest on his loan would save $4,000 per year on interest payments if the government accommodated a refinanced rate of 4%. Millions of Americans currently struggling to meet all of their monthly debt obligations while continuing to put food on the table and participate in the consumer economy would benefit from such a scheme. In its current form, Obama’s stimulus package with its $150 billion or so in tax cuts will only put approximately $500 per year for two years into taxpayers’ pockets.

As a homeowner paying a 6% mortgage myself, I can personally say I’d prefer $4,000 in savings on my annual interest payments for the next 23 years (the time remaining on my mortgage) than I would $1000 in cash over the next two years. The mortgage relief plan would result in nearly $100,000 less in interest payments, freeing that income up to be spent on goods and services and contributing to real job creation.

And check out last night’s “moment of Zen”. While Obama’s stimulus package is not quite $1 trillion, it is darn close. Senator Mitch McConnell puts the vast size of the spending bill into perspective for us:

Related posts:

1. Obama’s stimulus is “the first real test of Keynesian economic policy”
2. Fiscal stimulus, the Swiss way
3. Fiscal Stimulus package passes in Congress – here comes $170 billion, America!

BBC NEWS | Business | Sterling rebounds from sharp fall

Americans, are you planning a vacation anytime soon? If so, why not visit LOVELY Great Britain! Why, you ask, would ANYONE want to visit the UK in during this wet, cold season? Well, here’s why I’m buying British this year:

I recently booked a Himalayan ski tour in Indian Kashmir organized by a British company. The price? 1400 GBP, which only three months ago was the equivalent of $2800 US! Today, with the newly weak British Pound, my ski trip to India will only cost me $2100*. In the span of just a few months, the dollar price of this amazing Himalayan ski adventure has fallen by $700! Naturally, Americans like myself now have an incentive to buy British!

What has caused the slide of the Pound in recent months? Here’s the complicated answer:

“The environment of very weak sentiment regarding the domestic economic picture and potential rate cuts alongside equity volatility is keeping sterling very much on the defensive,” said Jeremy Stretch, strategist at Rabobank.

Strategists get paid lots of money to say stuff that 99% of people don’t understand the first time they read it. I get paid very little money to help those people better understand it, specifically, my students. Here’s what Mr. Stretch is trying to say:

A weak economy in Great Britain leads foreign investors to believe that the Bank of England may lower interest rates in the near future. Why would Britain’s central bank lower interest rates? Because lower interest rates create an incentive for consumers and businesses to take out loans from banks and spend money in the economy, which should create new jobs and help prevent a recession in the UK.

If the bank does lower interest rates, this puts “the sterling on the defensive”, in other words, leads to a weakening of the British Pound, as foreign investors looking to put their money where they can earn a decent return on it will be less likely to save in the UK when interest rates fall. “Equity volatility” is a fancy way of saying British stocks have been performing poorly, decreasing their attraction to foreign investors. When saving in British banks becomes less attractive due to expected interest rate cuts, and buying British stocks becomes risky due to their volatility, investors turn to the safest investment in the world, which is… can you guess? United States government bonds!

So how’s this all relate to exchange rates, you ask? Let’s leave this question for readers to answer and discuss in the comments:

Discussion Questions:

1. How does the expected drop in British interest rates affect the demand for British pounds on foreign exchange markets? What does this do to the value of the pound?
2. Why does the stability and safety of US government bonds lead to a strengthening of the dollar in times of global economic slowdowns?
3. How has the recession in the United States further contributed to the weakening of the British pound?

*In fact, I’m too poor to take a ski trip to India this year, I will have to settle for the puny peaks here in the Swiss Alps!

Related posts:

1. More on exchange rates: Winners and losers of a strong British pound
2. What’s got the dollar so weak in the knees?
3. Reflections on the weak dollar

Colbertnation | The Colbert Report Official Site | Comedy Central

Newsweek international edition editor Fareed Zakaria explains in clear terms the root causes of the United State’s economic hardships. Simply put, Americans have lived beyond their means for far too long.

When a household, a firm, or a national government spend more than it earns (in income or tax revenues), it must borrow to do so. The only problem with this type of deficit financed spending is that at some point “the only way people will keep lending you money is that you have to pay higher and higher interest rates…” This, according to Zakaria, is why the US economy has begun to slow down. Higher interest rates make borrowing and spending less and less attractive, while making savings more attractive.

Savings rates have started to rise in America as our debts have come due. Higher savings means less spending, less spending means weak Aggregate Demand, which means slower growth and rising unemployment. There you have it, the root cause of our economic meltdown. Americans have spent beyond their means for far too long; the question is, have we learned our lesson? Will our current hardships teach us to spend more responsibly in the future?

Related posts:

1. Those who foresaw the meltdown…
2. A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out
3. How big is the government spending multiplier in America? Well, it depends on which economist you ask…

Who’s specifically to blame for the economic situation we find ourselves in leading up to the $700B Federal bailout bill that is just about to be signed into law?

Assuming you have read my previous post (“U.S. Financial Crisis! What Is Really Happening?”) on this topic posted last week on this blog site, a related and logical question might be who is most to blame for the unfortunate economic situation we find ourselves in?

As you can imagine, there is plenty of blame to go around! Republicans are blaming Democrats and Democrats are blaming Republicans. Many are blaming household decision makers, greedy executives, and bank regulators “asleep at the switch”. In short, everyone is blaming everyone except for themselves. I have yet to see one person blame themselves, their agency, or their companies!

I see the answers to the “who is to blame” question as a 6-point answer. Keep in mind that these 6 reasons are strictly my opinions and many would either disagree or add to the list:

1. Imprecise regulatory law allowed the financial institutions to carry too high a ratio of mortgage-backed securities to collateralized debt.
2. Banking regulators (Banking Committee, FED, Regulators, etc.) should have screamed louder earlier! Although there are many documented attempts from specific people that did warn of this problem it was more a whisper than a scream.
3. Private lenders (and their CEOs) got greedy either lowering or violating their own lending standards in hopes of making more interest income by loaning to people who were very risk bets.
4. New law had been passed several years ago, urging that Fannie Mae and Freddie Mac make more loans to lower income households that carried much more risk.
5. Households borrowed more than they could afford. Citizens that borrowed need to share the blame with lenders, although I place lenders at a higher standard than borrowers.
6. New accounting regulations under Sarbanes Oxley (regulation passed after Enron) are too conservative causing assets like mortgage-related securities to be valued less than their economic value (true worth), which caused the bank debtor run on the bank.

Yes, there is a lot of blame to go around on this one! If there is any good news it is the hope that new regulation and oversight will occur in our “mixed” economy to help prevent this from ever happening again. Of course, there will be many other “next problems” but, hopefully, we will learn from our mistakes!

Discussion questions:

1. Who do you believe is most to blame for the circumstances leading up to this bailout?
2. Have you remained unbiased in learning that this issue is neither solely a Republican nor a Democratic issue?
3. Which presidential candidate gave you the most comfort as to how he explained his views on the bailout?

Related posts:

1. The Costs of the Bailout, More Government Debt
2. Robert Reich – the financial bailout represents “the worst type of trickle-down economics”
3. Deflation: why lower prices spell doom for any economy!