The Fed should focus on deflation | The greater of two evils | The Economist

Deflation: a decrease in the general price level of goods and services of an economy. Sounds great, right? Lower prices mean the purchasing power of our income increases, making the “average” person richer! On the surface, it could be concluded that deflation may actually be a good thing. And in some cases, it is!

If prices of goods are falling because of major technological advances (think of the price of cell phones and laptop computers over the last 20 years) or because of massive improvements in the productivity of labor and capital (think of the price of manufactured consumer goods during the Industrial Revolution), then deflation could be considered a sign of healthy economic growth. Put in terms an IB or AP Economics student should understand, a fall in prices caused by an increase in a nation’s aggregate supply is good, since it is accompanied by greater levels of employment and higher real incomes. But if the fall in prices is caused by a decline in spending in the economy (in other words, by a decrease in aggregate demand), the consequences can be catastrophic.

It just so happens that the United States, Great Britain, and my own home of Switzerland are all faced with demand-deficient deflation at this very moment. I’ll allow the Economist to elaborate:

…With unemployment nearing 9% (in the United States), economic output is further below the economy’s potential than at any time since 1982. This gap is likely to widen. House prices are not part of America’s inflation index but their decline is forcing households to reduce debt , which could subdue economic growth for years. As workers compete for scarce jobs and firms underbid each other for sales, wages and prices will come under pressure.

So far, expectations of inflation remain stable: that sentiment is itself a welcome bulwark against deflation. But pay freezes and wage cuts may soon change people’s minds. In one poll, more than a third of respondents said they or someone in their household had suffered a cut in pay or hours…

Does this matter? If prices are falling because of advancing productivity, as at the end of the 19th century, it is a sign of progress, not economic collapse. Today, though, deflation is more likely to resemble the malign 1930s sort than that earlier benign variety, because demand is weak and households and firms are burdened by debt. In deflation the nominal value of debts remains fixed even as nominal wages, prices and profits fall. Real debt burdens therefore rise, causing borrowers to cut spending to service their debts or to default. That undermines the financial system and deepens the recession.

From 1929 to 1933 prices fell by 27%. This time central banks are on the case. In America, Britain, Japan and Switzerland they have pushed short-term interest rates to, or close to, zero…

…inflation is easier to put right than deflation. A central bank can raise interest rates as high as it wants to suppress inflation, but it cannot cut nominal rates below zero… In the worst case, rising debts and defaults depress growth, poisoning the economy by deepening deflation and pressing real interest rates higher….Given the choice, erring on the side of inflation would be less catastrophic than erring on the side of deflation.

Discussion Questions:

1. Deflation poses several threats to an economy that is otherwise fundamentally healthy, such as the United States’. What are some the threats posed by deflation?
2. The expectation of future deflation can have as equally devastating effect. Why is this?
3. What evidence does the article put forth that an economy experiencing deflation may eventually “self-correct”, meaning return to the full employment level of output in the long-run?
4. Why don’t governments and central banks just sit back and let the economy self-correct? In other words, why are fiscal and monetary policies being used so aggressively by the US, Great Britain and Switzerland during this economic crisis?

Deflation or Inflation:Watch the video below, see if gives you any clues as to the causes and effects of deflation. What do you think John Maynard Keynes would say in response to the deflationary fears expressed in the Economist article?

Economic View – A Dose of Skepticism on Government Spending – NYTimes.com

We all understand that fiscal stimulus is one of the tools that governments can use to increase the level of economic activity during a recession. The fiscal medicine can be delivered in one of two ways. The government can tweak the tax systems to boost incentives to spend and work or it can increase government spending. One tool that we can use to evaluate the merits of these two policies is to compare the relative multipliers that relate to government spending and taxation.

The multiplier is the key component of Keynesian theory and shows the possibility of a given increase in injections, e.g. government spending, investment and exports, increasing aggregate demand by more than the initial value. This logic fits with our understanding of the circular flow where say increased government spending will lead to increased derived demand for other products, and increased demand for labour. Workers will spend additional wages on other products which leads to further increases in aggregate demand. This flow on effect can be diluted by withdrawals from the system such as taxation or savings.

Greg Mankiw wrote an excellent analysis of this issue in the New York Times in Janurary. “A dose of skepticism on government spending”

An essential skill for IB and AP Economics students is to be able to evaluate the effectiveness of Keynesian  demand-side policies as well as classical supply-side policies, both fiscal and monetary. An understanding of multipliers can improve a student’s ability to evaluate fiscal policy. Greg writes:

“Economics textbooks, including Mr. Samuelson’s and my own more recent contribution, teach that each dollar of government spending can increase the nation’s gross domestic product by more than a dollar. When higher government spending increases G.D.P., consumers respond to the extra income they earn by spending more themselves. Higher consumer spending expands aggregate demand further, raising the G.D.P. yet again. And so on. This positive feedback loop is called the multiplier effect.

In practice, however, the multiplier for government spending is not very large. The best evidence comes from a recent study by Valerie A. Ramey, an economist at the University of California, San Diego. Based on the United States’ historical record, Professor Ramey estimates that each dollar of government spending increases the G.D.P. by only 1.4 dollars. So, by doing the math, we find that when the G.D.P. expands, less than a third of the increase takes the form of private consumption and investment.”

This low multiplier effect implies that any government spending must be used in an effective manner where it will increase the long-term productivity of the country. During a “jobs think-tank” recently in New Zealand, a media release announced an idea of the government spending a vast sum of money to develop a walking track from one end of the country to the other. Would this lead to increased tourism? How much money would these hiking visitors spend? Would it create more jobs?

Should we therefore expect that tax cuts will lead to a greater increase in GDP through the feedback loop compared to government spending? Well, we have to remember that not all tax cuts will be spent immediately, according to the marginal propensity to consume. In a recession some workers will be pessimistic about the future and save the money. Will tax cuts compensate workers who are working shorter hours? Greg suggests that tax cuts might actually be more potent than government spending according to current research.

“Textbook Keynesian theory says that tax cuts are less potent than spending increases for stimulating an economy. When the government spends a dollar, the dollar is spent. When the government gives a household a dollar back in taxes, the dollar might be saved, which does not add to aggregate demand.

The evidence, however, is hard to square with the theory. A recent study by Christina D. Romer and David H. Romer, then economists at the University of California, Berkeley, finds that a dollar of tax cuts raises the G.D.P. by about $3. According to the Romers, the multiplier for tax cuts is more than twice what Professor Ramey finds for spending increases.

Why this is so remains a puzzle. One can easily conjecture about what the textbook theory leaves out, but it will take more research to sort things out. And whether these results based on historical data apply to our current extraordinary circumstances is open to debate.”

So the current research indicates that one-dollar of tax cuts can increase G.D.P by $3 compared to an additional dollar of government spending increasing GDP by $1.40. But why is there such a large difference? Is this related to the arguments about the efficiency of increased government spending? The verdict is still out and we may need to wait till the next global recession to find out.

Below is a picture of the aptly named Bridge to Nowhere located in the central North Island of New Zealand. It was built by the government in a spending splurge in the 1936 to open up land in the area. The land is now no longer fertile or accessible and all access to the area is cut off except for this concrete relic. The area is now popular with trampers.

Discussion Questions:

1. How do economists calculate the multiplier?
2. What are leakages from the circular flow that reduce the multiplier effect?
3. Explain the link between the accelerator model and the multiplier.
4. What would multipliers for other injections such as export receipts or investment look like? Would they be higher or lower than multipliers for taxation or government spending?
5. Evaluate the effectiveness of fiscal stimulus to increase the level of economic activity.

Why Are Large Companies Losing More Jobs Than Small Ones? – TIME

This is a fascinating, short article from TIME. Before reading it, see if you can answer the multiple choice question below:

Q: Why do small companies lay off proportionately fewer workers during a recession than large companies?

A) Because small firms are less likely to be in the industries hardest hit by a recession (such as manufacturing)?
B) Because small firms are less focused on maintaining profits to satisfy greedy shareholders?
C) Because small companies are able to hang on to employees and even hire new ones during a recession because of all the talent being laid off by big firms.

Still thinking? Well, it’s likely that all three are true to some extent. But it’s the third one that seems most intriguing as a student of economics. Here’s what the article says:

…small companies hire disproportionately more early on in an economic recovery because it’s easy for these firms to find good workers while unemployment is still high—and easy for workers to come across small companies since there are so many of them. Once the economy is chugging along at full-steam and the labor market is tight, larger companies regain the advantage, since they’re likely able to offer more money—and poach from smaller outfits.

Seems pretty straight forward, right? Sure, but the fact that small firms are likely to hire when unemployment is high supports one side in a long-running economic debate over the economy’s ability to “self-correct” in times of recession.

As any student of Macroeconomics learns early on, there are two dominant theories of macroeconomics, both which are represented in the aggregate demand/aggregate supply diagram that we learn and use in AP and IB Economics.

The two models below represent the two opposing views of macroeconomics. First we see the Keynesian model, which shows that when overall demand in an economy falls, unemployment increases drastically and output tanks, plunging the economy into a deep recession. This is primarily because of the “inflexible” nature of wages, meaning that even when unemployment rises, workers are unwilling to accept lower wages and firms therefore are unwilling to hire more workers.

According to Keynesians, the only way to get the economy out of the recession is by increasing overall demand through heavy doses of government spending (case in point, the $775 billion stimulus in the US).

Next is the Classical AD/AS model with a vertical long-run aggregate supply curve. The implication of the vertical AS curve is that regardless of the level of overall demand in the economy, output will always return to the full-employment level, and thus unemployment will always return to its natural level. The major assumption underlying the Classical model is that wages are in fact flexible in times of recession. As unemployment rises, workers will accept lower wages since they’d rather be making less than making nothing at all. As wages fall firms will begin hiring more workers, increasing overall output and decreasing unemployment until full-employment output is restored.

The implication of the model on the right is that government is NOT needed to get the economy out of a recession, because it will self-correct due to the new hiring and production by firms in response to falling wages in the labor market.

The reason this article stood out to me was that it seems to offer some evidence in support of the flexible-wage, Classical model of macroeconomic self-correction. There has been surprisingly little talk among news anchors, pundits and politicians about the likelihood of the US or ANY economy suffering in the global slowdown “self-correcting” as the Classical model would suggest it should. But the fact that small businesses are less likely to lay off workers in a recession and more likely to begin hiring them due to the large number of workers being laid of by big companies offers at least an inkling of evidence in support of the Classical model of flexible wages and macroeconomic self-correction.

Discussion Questions:

1. Why is laying off workers the first thing big companies do when faced with falling demand for their products? Why don’t they shut down factories instead?
2. What pressures does a publicly traded company (one that sells stocks to investors) face in times of recession that a small, privately owned business does not?
3. When the global recession is finally over, do you think more people or fewer people will be working for small companies (less than 50 people) than before the recession? What would you rather work for, a small firm or a large one? Why?

CBO Director’s Blog » Macroeconomic Effects of the Senate Stimulus Legislation

The February 9th edition of the excellent NPR show, Planet Money reported on a letter sent from the director of the Congressional Budget Office to the Senate, forecasting the (In macroeconomics): The period of time over which wages and prices are relatively inflexible. A fall in aggregate demand will lead to unemployment and recession in the short-run. Due to the inability of the nation's producers to reduce wages paid to worker, they must lay workers off to reduce costs as demand falls.');" onmouseout="tooltip.hide();">short-run and long-run macroeconomic effects of the House Stimulus Package.

Crowding-out and the Stimulus Package [ 1:23 ] Play Now | Play in Popup | Download (19)

It turns out the director of the CBO has his own blog on which he published his letter to the Senate. Here are some highlights:

CBO estimates that the Senate legislation would raise output by between 1.4 percent and 4.1 percent by the fourth quarter of 2009; by between 1.2 percent and 3.6 percent by the fourth quarter of 2010; and by between 0.4 percent and 1.2 percent by the fourth quarter of 2011. CBO estimates that the legislation would raise employment by 0.9 million to 2.5 million at the end of 2009; 1.3 million to 3.9 million at the end of 2010; and 0.6 million to 1.9 million at the end of 2011…

Most of the budgetary effects of the Senate legislation would occur over the next few years. Even if the fiscal stimulus persisted, however, the short-run effects on output that operate by increasing demand for goods and services would eventually fade away. In the long run, the economy produces close to its potential output on average, and that potential level is determined by the stock of productive capital, the supply of labor, and productivity. Short-run stimulative policies can affect long-run output by influencing those three factors, although such effects would generally be smaller than the short-run impact of those policies on demand.

In contrast to its positive near-term macroeconomic effects, the Senate legislation would reduce output slightly in the long run, CBO estimates, as would other similar proposals. The principal channel for this effect is that the legislation would result in an increase in government debt.  To the extent that people hold their wealth in the form of government bonds rather than in a form that can be used to finance private investment, the increased government debt would tend to “crowd out” private investment—thus reducing the stock of private capital and the long-term potential output of the economy.

The negative effect of crowding out could be offset somewhat by a positive long-term effect on the economy of some provisions—such as funding for infrastructure spending, education programs, and investment incentives, which might increase economic output in the long run. CBO estimated that such provisions account for roughly one-quarter of the legislation’s budgetary cost. Including the effects of both crowding out of private investment (which would reduce output in the long run) and possibly productive government investment (which could increase output), CBO estimates that by 2019 the Senate legislation would reduce GDP by 0.1 percent to 0.3 percent on net.

The fascinating thing about this letter from the Congressional Budget Office to the Senate is that it mentions so many of the Macroeconomic principles we teach in both AP and IB Economics.

• The nation’s potential output (PPC) is “determined by the stock of productive capital, the supply of labor, and productivity”.
  
• Fiscal stimulus’ effects, while possibly significant in the short-run, may result in less long-run growth due to “crowding-out” of private investment as the public puts its savings into government debt and takes it out of the market for loanable funds.
• A stimulus package should be made up of “funding for infrastructure spending, education programs, and investment incentives, which might increase economic output in the long run.” The negative effects of crowding-out could be offset through responsible government spending.

I find this letter to be surprisingly positive. The short-run forecast seems optimistic: as much as 3.6% GDP growth and as many as 3.9 million new jobs by the end of 2010. The negative growth effects of the stimulus resulting from increased government debt and the subsequent “crowding-out” of private investment are not predicted to set in until 2019.

I always tell my students that humans are “short-run creatures living in a long-run world”. I have to admit, this short-run creature is inclined to think that a stimulus package that puts nearly 4 million people to work and turns the US Economy back onto a path towards growth within two years is probably worth the long-run risk of sluggish growth ten years down the road due to the decline in private investment resulting from the debt-financed spending today.

This letter from the CBO also seems to address a debate recently undertaken in the AP Economics teacher email list: whether deficit-financed government spending affects the supply of or the demand for loanable funds in the economy.

To the extent that people hold their wealth in the form of government bonds rather than in a form that can be used to finance private investment, the increased government debt would tend to “crowd out” private investment—thus reducing the stock of private capital and the long-term potential output of the economy.

This passage from the director’s letter indicates that it is the supply, not the demand for loanable funds that shifts, driving up real interest rates in the economy. Savers will take their money out of banks and other lending institutions and put it in government bonds, reducing the amount of capital available for private investment. This can be illustrated as a leftward shift of the supply of loanable funds.

Discussion questions:

1. In evaluating the use of expansionary fiscal policy, we learn in IB Economics that the crowding-out of private investment will reduce the expansionary effect of increased government spending. Is crowding-out a problem during a recession? Why or why not?
2. Discuss the following statement: “In order to finance its budget deficit, the US government must borrow from the private sector.” How does the government borrow from the American people?
3. Will fiscal stimulus in the short-run lead to increased growth or decreased growth in the long-run? Discuss.

On my way to work this morning I listened to the latest episode of WEBZ Chicago Public Radio’s excellent show This American Life. The theme of this week’s radio show was “the New Boss”. America’s new boss, Barack Obama, has embarked on an ambitious experiment aimed at rescuing the American economy from the most severe recession it has seen since the Great Depression. The economic theory behind Obama’s nearly $1 trillion economic stimulus package was developed by a man we have all heard of in our AP and IB Economics classes, but probably know little about in a historical sense.

The clip from This American Life that I have included below presents a fascinating examination of Keynes’ life and times, and puts his theory into perspective in the history of macroeconomics of the last century. We learn that Keynesian theory has not been truly put to the test, and that Obama’s $830 billion stimulus package is the first real test of Keynesianism.

Keynes.mp3 [ 0:01 ] Play Now | Play in Popup | Download (29)

The clip is a bit long, but it is definitely worth listening to if you are a student or teacher of economics. I know that when I come teo Macroeconomics and Fiscal Policy in my course this spring, I will have my kids listen to and discuss the podcast below. If you’re teaching or learning Macro now, feel free to listen and leave comments about your impressions of the story here.

FT.com / China / Economy & Trade – China’s 20m unemployed raise risk of unrest

The days of full-employment in China appear to be over. For decades under communism, the unemployment rate in China stood at an official level of 0%. Of course, being guaranteed work by a state-owned farm or steel factory didn’t exactly mean that all adult Chinese were “working”, rather that they were “employed”. The “iron rice bowl” of communism disappeared in the decades following Mao’s death during the period of “reform and opening” begun under Deng Xiaoping in 1979.

Upon its opening to the world markets, China embarked on three decades of transition from command to market economic principles, characterized by near double digit growth. The demand for workers in its export sector, centered mostly in the Eastern cities from Shenzhen in the south to Shanghai and Beijing in the north, led to the largest rural to urban migration in human history, as nearly 300 million Chinese left the countryside to seek employment in the country’s massive export sector.

Today, the very engine of China’s growth is sputtering to a halt. The demand for Chinese exports is falling as unemployment rises and incomes fall among its trading partners in Asia and the West. Subsequently, the flow of labor from the countryside to the city has reversed, and for the first time in its long history, China is experiencing urban to rural migration:

More than 20m rural migrant workers in China have lost their jobs and returned home as a result of the global economic crisis according to government figures, raising the spectre of widespread unrest in the authoritarian country.

By the start of the Chinese New Year Spring Festival on 25 January, 15.3 per cent of China’s 130m migrant workers had lost their jobs and returned from manufacturing centres in the south and east of the country to their home villages or towns, according to Chen Xiwen, Director of the Office of Central Rural Work Leading Group, who was quoting a survey from the Ministry of Agriculture.

What does the new demographic trend mean for the world’s most populous nation? Bad news, most likely. The hope of work in the city dwindles with demand for Chinese products, but the agricultural sector, which is the main source of employment in the countryside, shows little promise of employment for the millions returning home.

China’s farming industry has become less, not more, labor intensive over the decades since “reform and opening”. The acquisition of capital has supplanted the need for human labor in rural farming, which is one of the “push factors” that led to the massive internal migrations to cities in the first place. The “pull factor” leading the masses to the coastal metropolises, of course, was employment in a factory producing goods to be exported to foreign markets.

Today China’s workers find themselves in the worst possible situation. There is now a “push factor” of 15-20% unemployment, combined with the high cost of living and the struggle of living as an outside in a big city creating an incentive for Chinese workers to return to their familial homes in the countryside. But once they’ve returned home, they find the same lack of opportunity that caused them to leave in the first place. Urban unemployment may shrink as a result of the reverse migration of workers, but rural unemployment will rise.

For the first time in decades, China is faced with a problem that only a year ago (when growth reached 11%!) most would have thought it unlikely to ever face: catastrophic unemployment. Economic theory would suggest, therefore, that China is facing a situation where falling demand for its output has led to rising unemployment due to the downwardly inflexible nature of workers’ wages. According to the Keynesian AD/AS model above, if demand for Chinese output is not restored on its own (which seems unlikely as the West enters deep recession), then the government must take an active approach to stimulating demand through expansionary fiscal and monetary policies.

Keynesian theory, formulated during the Great Depression of the 1930′s, says that in times of recession, spending in the economy is unlikely to increase on its own due to the huge increases in unemployment and corresponding lack in consumer and investor confidence. An active role of government, therefore, is needed to supplant the fall in private spending, and create new income, spending, and economic growth.

In contrast to this “demand-side” theory of macroeconomics, the neo-classical economist would argue that China’s government would do best by letting the economy “self-correct” in times of economic slowdowns. The graph below shows that as demand for China’s output falls in the (In macroeconomics): The period of time over which wages and prices are relatively inflexible. A fall in aggregate demand will lead to unemployment and recession in the short-run. Due to the inability of the nation's producers to reduce wages paid to worker, they must lay workers off to reduce costs as demand falls.');" onmouseout="tooltip.hide();">short-run, unemployment will rise and the price level will fall as firms find it hard to sell their output. Because millions are out of work, and because prices are lower, labor will be willing to accept lower wages, encouraging firms to increase their employment of labor, shifting aggregate supply outward and ultimately restoring full-employment at a new, lower price level than before the downturn began. This classical laissez faire theory of “self-correction” has by most account been proven FALSE, as most major recessions, most notably the Great Depression itself, were ended only after massive intervention by the national government.

The most promising solution to the looming social and economic nightmare it faces is for the Chinese government to push forward massive fiscal stimulus plans aimed at putting the tens of millions recently jobless back to work. This may sound like a return to communism at first, but government money can be spent to create jobs in private enterprise, producing goods, services, and infrastructure that leads to real long-run economic growth fueled by domestic, not foreign, demand for Chinese output.

For too long China has depended on demand from the rest of the world to grow its economy. Faced with the largest economic crisis of the modern era, the Chinese Communist Party should take it upon itself to reduce the nation’s dependency on foreign demand, stimulate growth through new public spending on infrastructure, education, health care and social security for the hundreds of millions of Chinese who are left to fend for themselves once they’ve reached retirement age. Meaningful fiscal stimulus aimed at improving the lives of the common citizen, of whom so many have been adversely affected by China’s over-dependence on export-oriented growth, will may be the best response to the most dire social and economic turmoil the country has faced since the end of the Mao era over 30 years ago.

Discussion questions:

1. What is China’s most worrying macroeconomic problem currently? Inflation? Recession? Unemployment? Deflation? Trade imbalance? Income distribution? Which of these does falling demand for China’s exports affect most?
2. What are the social and economic costs of rising unemployment and why is it so important for a government to combat it?
3. Discuss the differences in the Keynesian and the Classical models in their explanation of what will happen to unemployment after a fall in Aggregate Demand.

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?

Thanks to my friend Jerry from Shanghai for posting this cartoon to his Facebook profile!

How timely, just as my year 2 IB Economics class is studying the pitfalls of expansionary fiscal policy in times of economic slowdowns. Now, many critics would say that Clinton was the luckiest president of recent decades as he happened to ride a wave of technological innovation fueled by the internet that led to unprecedented grown in income and tax revenue during the 1990s. Sustained 5% growth combined with a period of relative peace on the foreign fronts in between the two Gulf Wars allowed Clinton to balance the budget and begin putting a dent in the country’s $3 trillion deficit during his final years in office.

Along come the “fiscally conservative” Republicans and their faithful leader GWB, just in time to evaporate our budget surplus and add $6 trillion to our national debt over the next eight years. Today, after a long period of “fiscal conservatism” the debt stands at $9.3 trillion, and last year’s budget deficit of $400+ billion broke a record for the largest gap between tax revenue and government spending in US history.

Yeah, you can blame it one the times: a War on Terror costing the US roughly a billion bucks a day, a slowdown in new technology creation, diminishing returns on internet investments, out-sourcing of American industry and jobs, yada yada… but the cartoon does hold some truth. The Democratic Party, long labeled as the “tax and spend liberals”, managed to do what few other administrations have done since the ’60s in balancing the budget, proving that the old stereotype is simply wrong.

Some now consider the Democrats the fiscally conservative party, based only on the simple observation that they tend to spend closer to what they collect in taxes. The Republicans, on the other hand, have had no qualms about spending what they DON’T collect in taxes, in other words, running up huge budget deficits through borrowing from the public and abroad. Are the Republicans the an even worse incarnation of the “tax and spend liberals”? Are they the “DON’T tax and STILL spend Conservatives”?

Discussion questions:

1. How did the Bush administration’s $160 billion “fiscal stimulus package” that sent $600 checks to every American worker demonstrate the Republican party’s willingness to deficit spend.
2. What effect will deficit spending by the government have on interest rates and private investment in the economy? What is this effect known as?
3. In times of weak aggregate demand, as in the US earlier this year, what sort of approach would a “supply-sider” recommend as an alternative to Bush’s deficit-financed expansionary fiscal policy?

Wednesday’s class this week was one of my favorite of the year. Why? We got to talk taxes. Oh my goodness, you say, what’s wrong with Welker? How could he actually enjoy talking about taxes? As I said at the beginning of class, there are only two certainties in life: death and taxes.

For most people, taxes are a dismal subject, to say the least. But for teachers of economics, especially in this presidential election year, taxes make for an exciting economic, political and philosophical debate.

The premise of our discussion in class was the idea put forth by Arthur Laffer nearly 30 years ago towards the beginning of the Regan administration: that if the government would cut taxes on businesses and households, the incentive to invest and work would increase so much that gains in total output and income would be such that the government’s tax revenue might actually increase, despite the tax cut! Cutting taxes on the wealthy would have the greatest positive effect, however, since it’s the wealthy who do most of the investing and much of the spending in the economy.

This basic philosophy underpinned the tax cuts the wealthy enjoyed during Regan’s presidency, and again during George W. Bush’s term in 2001 and 2003. The debate about whether taxes cuts made by the current president is one at the heart of the Democratic/Republican divide today.

Watch the videos below, then answer the questions that follow:

First, the Democratic view:

Then the Republican view:

Discussion questions:

1. Why do Obama and Clinton promise that if they’re elected we’ll “go back to the tax rates we had before President Bush”?
2. What is McCain’s criticism of Obama’s view on taxes?
3. What do you think about the “supply-side” argument that lower taxes will stimulate spending, growth, employment, and possibly even the amount of tax revenue collected by the government? Do you buy it?
4. Are you a “supply-sider” or more of a Keynesian when it comes to the role of government in the economy? What’s the difference?

OECD Cuts Growth Forecast to Below 2% – Bloomberg.com

The Organization for Economic Cooperation and Development predicts a global slowdown in growth. Among its 30 member nations, the OECD predicts growth of below 2% for 2008.

The [OECD] cut its forecast for expansion this year in its 30 member nations to “less than” 2 percent, the weakest since 2003. This “will be a difficult year of lower growth and some more unpleasant surprises,” OECD Secretary General Angel Gurria said in an interview in Oslo. “We have revised downwards a number of our projections.”

Okay, 2% isn’t that bad, right? I mean, it’s still growth. In fact, the OECD believes the strongest growth will be in emerging economies such as China and India, which it predicts will grow at 6.9%. The US and Europe may not enjoy such comfortable rates of expansion in this time of restricted credit, low consumption and investment and dwindling optimism among households and firms.

Jean-Luc Schneider, deputy director of the OECD’s economics department, said the agency is “not yet completely convinced there will be a recession” in the U.S., though it will be “flirting” with contraction. That will affect other OECD economies, especially those in Europe, said Gurria.

While European growth won’t be as “uncomfortable” as in the U.S., it’ll “probably be worse than we know today…”

In times of macroeconomic weakness as described above, an active role for government may be required in order to stimulate consumption and investment, increase aggregate demand and restore a healthy rate of economic growth.

Keynesian economists advocate an active role for government and central banks in times of recession. The Keynesian school of economics rests on the theory of downwardly inflexible wages and prices, the implication being that in times of declining demand (low investment and consumption), the economy slides into recession characterized by rising unemployment and slow or negative growth. (as illustrated in the graph here)

The classical view of recession, however, holds that as employment and output decline, the price level will fall due to weak aggregate demand. This “flexible price” theory leads classical economists to argue that if left alone, the economy will self-correct because workers will eventually accept lower wages, leading firms to hire more workers, increase output, and restore full-employment (as shown in the graph on the left). No government intervention is needed in such a scenario.

Keynesians argue that “flexible prices” are a myth, that in times of recession prices may remain high or even rise (in the case of a supply-shock as illustrated in the graph below). Due to the “sticky prices”, workers are not willing to work for lower wages, thus firms are not able to increase their employment in a time of weak aggregate demand. Without downwardly flexible wages, aggregate supply will not adjust outwards to restore full employment output.

Keynesian economists therefore support action by the government and central banks in times of slow or negative growth. In America today, the mainstream view adopted by most macroeconomic policy makers is still rooted in Keynesian theory, which explains the government’s recent fiscal stimulus package and expansionary monetary policies undertaken by the Fed.

Expansionary policies like a tax rebate, the Fed’s buying of bonds on the open market, and the lowering of the discount rate are aimed at shifting Aggregate Demand outward to restore full employment. The problem is that in addition to weak demand, the world economy is simultaneously experiencing rising costs of production as a result of record energy and food prices.

Cost-push inflation and rising unemployment pose a whole new policy challenge for central bankers and politicians. To combat recession in the face of rising prices is tricky, as the trade-off between unemployment and inflation is tenuous. The Phillips Curve illustrates the inverse relationship between the inflation rate and the unemployment rate. To understand the logic of this model it is useful to examine the current challenge face by the Fed.

Both unemployment and inflation are rising in the US right now. The reason for this is the rising costs faced by firms due to a weak dollar combined with high energy and food prices. Normally, a Keynesian approach to recession alleviation would be in order to restore full employment. Stimulating spending through expansionary policies, however, will only worsen the inflation problem.

The “supply shock” faced by America today has caused both unemployment and inflation to increase, which is illustrated by an outward shift in the Phillips Curve. The best policy action in this scenario may, in fact, be to allow the US to enter a recession; in other words, no policy, or laissez faire.

If the US and European economies are allowed to experience a significant slowd0wn or contraction in growth, the global demand for commodities such as fossil fuels, minerals, and other raw materials for production should decline, putting downward pressure on these commodity prices. In addition, rising unemployment should eventually result in workers accepting lower wages. The combination of falling commodity prices and wages should encourage firms to increase output, shifting aggregate supply outward and the Phillips Curve inward, restoring full-employment and price level stability.

In all likelihood we will not see the above scenario transpire. Governments and central bankers are already making moves to maintain growth and low unemployment, even in the face of rising prices. The Keynesian/classical debate, however, will continue. For now, at least, it seems as if the Keynesians are still winning the battle of the hearts and minds of political and economic leaders today.