FT.com / Columnists / Wolfgang Munchau - Inflation and the lessons of the 1970s

It seem that everyone’s speculating about the US economy today. Recession or no recession, that is the question. The economy has even surpassed the Iraq War as the number one issue in the US presidential race! John McCain, who has publicly admitted that economics is not his strong suit, may just find himself in trouble in a general election where the most important concern among voters is the economic situation.

So what IS that situation, anyway? Is the US in a recession? In other words, has real gross domestic, or total output in the US economy, actually declined over the last six months? Technically, the answer is no. My fellow blogger, Steve Latter, explains this clearly here. What is true, on the other hand, is that the current situation shares many similarities to the global economic slowdown that did occur in the 1970s.

In 1973 OPEC, the newly formed oil cartel consisting at the time of only Arab states, reduced its output of oil and cut off exports to the United States in response to US support of Israel in the Yom Kippur War, in which the Israelis officially occupied the Palestinian territories of the West Bank and Gaza and seized the Golan Heights from the sovereign nation of Syria. To punish the US for its position on this conflict, OPEC cut off supplies of oil to the west, driving gas and energy prices upwards by 70%, triggering a supply shock characterized by a decline in total output and an increase in both unemployment and inflation, a phenomenon known as stagflation: a macroeconomic policy maker’s worst nightmare.

Recently the world has seen a similar (albeit of a different cause) rise in the price of oil and energy prices. Today the rise in energy prices is driven primarily by rising demand, rather than reduced supply (since the 1970s the OPEC cartel has grown to include many non-Arab nations, making it harder to achieve collusion to restrict output and drive up oil prices). Global demand for oil has risen steadily, driven ever higher due to rapid growth in China and other developing nations, and exacerbated by the falling value of the dollar, the currency in which oil prices are denominated.

The supply shocks of today have combined with falling aggregate demand in the US due to weak consumer spending to slow real growth rates to nearlry 0%. So technically, the US has avoided a recession, but the effect on American workers and consumers may be just as painful as the real recession of the 1970s. In order to prevent the “r” word from becoming a reality today, central banks (including the US Fed) have eased money supplies, lowering interest rates, fueling even greater increases in the price level.

…the global weighted average inflation rate will be 5.4 per cent this year, while the global money market interest rate is currently only 4.3 per cent. This means that global short-term real interest rates are negative – at a time when inflation is rapidly accelerating. As monetary policy has been excessively accommodating for more than a decade, inflationary pressures have built up in the global economy.

Central bankers like Ben Bernanke have to make tough decisions sometimes, weighing the trade-off between unemployment and inflation, and determining their monetary policies based on whatever they deem to be the “lesser of two evils”. Rising energy prices have forced firms to cut either cut back their production and raise the price of their products, both actions that result in less overall spending and output in the economy. Falling house prices have led consumers to cut back their own spending, further reducing demand for firms’ output. These factors have all pushed the unemployment rate from around 4.8% a year ago to 5.1% today, which combined with an estimated additional 3-5% of American workers having dropped out of the workforce, (referred to by the Department of Labor as “discouraged workers”) paints a pretty ugly picture of the reality for the American worker today.

The harsh reality of the weak labor market has led Mr. Bernanke and the Fed to pursue an expansionary monetary policy aimed at avoiding further increases in the unemployment rate and decreases in the GDP growth rate. Expansionary monetary policy means lower interest rates, with the goal being increased consumption and investment, both factors that could worsen the inflation problem already experienced thanks to the global supply shock. Evidence indicates that the inflation problem, even in the US where slow growth usually leads to lower price levels, is not going away:

In the US, a survey-based measure of inflationary expectations recently showed an increase to more than 5 per cent. I would estimate there are now several hundred basis points of difference between the current Fed funds rate and an interest rate that would be consistent with price stability in the medium term.

…meaning the Fed, in its attempt to avoid recession and rising unemployment, has created a condition where real interest rates are actually negative, a highly inflationary condition. All this wouldn’t be so bad if wages in the US were rising along with the price level. This however, does not appear to be happening:

The main difference between the situation in the 1970s and now is today’s absence of wage inflation, which explains why absolute inflation rates are a little more moderate. I guess this is probably because of some combination of deregulated labour markets and globalisation. But the lack of wage-push inflation is not necessarily good news. Falling real wages mean falling disposable income and tighter credit conditions mean less borrowing for consumption.

Rising prices for energy, transportation and food have put American households in a tough situation. In the past, periods of inflation have often been characterized by rising wages, meaning the full brunt of nominal price level increases was not entirely born by the American worker. Today, on the other hand, a recession has thus far been avoided, but the combination of record numbers of “discouraged workers”, rising unemployment and inflation may make the pain of our current economic situation just as real as recessions of the past.

In the words of billionaire investor and economic sage Warren Buffett just today:

“I believe that we are already in a recession… Perhaps not in the sense as defined by economists. … But people are already feeling the effects of a recession.”

“It will be deeper and longer than what many think,” he added.

Discussion Questions:

1. What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?
2. What impact do rising energy prices have on the behavior of individual firms?
3. Why are low interest rates likely to make the inflation problem even worse?

Yes, but it’s a bit more complicated than it might seem at first. This podcast looks at the impact of the falling dollar on the aerospace industry, in which manufacturing for the industry’s largest firms is sourced to hundreds of smaller companies each with factories in countless countries from North America to Europe to Asia.

The recent fluctuations in the US dollar exchange rate has wreaked havoc for firms located in the US and trying to compete in this competitive market. In some cases, the outcome has been positive, but as you’ll hear, not always.

Listen to this podcast then discuss the questions below:

 

 Weak Dollar Can Bode Well for Manufacturers [5:18m]: Play Now | Play in Popup | Download

Discussion Questions:

1. How has the weaker dollar helped the Connecticut firm Kamatics?
2. How has Kamatics been hurt by the weaker dollar?
3. Why do fluctuations in the dollar make “business more unstable”?
4. How does the impact of currency swings become more ambiguous “as the economies of the world become more intertwined”?
5. Why did EchoAir stop manufacturing products in Romania? What impact would a revaluation of the Chinese Yuan have on EchoAir’s current manufacturing decisions?

FT.com / World - American dream hit by dollar’s decline

Ever wonder if there was a connection between the strength of a country’s currency and the flow of immigrants into that country? No? Me neither… but interestingly it appears that there is a direct relationship between these variables. The weaker a country’s currency, the fewer immigrants cross its borders to find work. Here’s why:

Migrant workers are choosing to move to Europe, Australia or Canada instead of the US in order to protect the purchasing power of the money they send home to their families, according to one of the world’s leading experts on remittances.

The shift is a result of sharp falls in the value of the US dollar against other international currencies, many of which have been boosted by the rise in commodity prices.

This news may make some American’s happy, since it could mean more opportunities for the American workers who may have lost their jobs during the current recession. This, however, may not be the case. It turns out that much of the decline in immigrant workers is in high skilled fields for which demand for workers in the US remains high even in times of recession. According to the article, “the trend was especially notable among skilled workers, such as doctors, nurses and information technology specialists”.

A decline in the inflow of high skilled workers may actually make Americans worse off. I have blogged about the shortage of American workers in fields such as engineering, software design, and natural gas rig technicians,and I don’t think many Americans would argue that health care in America is already too cheap, so I suspect that more doctors and nurses would be desired.

A weak dollar has many effects on America. In some ways, it makes the country better off. As I have blogged about here, a weak dollar should lead to more balanced trade, a boom for US manufacturers, and an increase in exports, all related, of course, to the relative decline in prices of US goods to foreign consumers. But a weak dollar may in fact do more harm than good, one reason for which is explained here: skilled foreign workers whose talents are in strong demand in the US are moving more and more to European markets to find work.

Anti-immigration hawks may be cheering, but American consumers may start rearing as high-skilled labor shortages drive up wages and prices in the markets Americans most depend on today: health care, energy and technology.

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At Charter School, Higher Teacher Pay - New York Times

A New York charter school opening this year will start teachers’ pay at $125,000. The school’s creator and principal believes that quality teachers, not technology, are what will lead to results for students at his school.

The school’s creator and first principal, Zeke M. Vanderhoek, contends that high salaries will lure the best teachers. He says he wants to put into practice the conclusion reached by a growing body of research: that teacher quality — not star principals, laptop computers or abundant electives — is the crucial ingredient for success.

“I would much rather put a phenomenal, great teacher in a field with 30 kids and nothing else than take the mediocre teacher and give them half the number of students and give them all the technology in the world,” said Mr. Vanderhoek, 31, a Yale graduate and former middle school teacher who built a test preparation company that pays its tutors far more than the competition.

This is certainly an interesting experiment. American schools have struggled for decades to improve results through the implementation countless programs and policies. Lately, one emphasis has certainly been on technology; but this article makes an interesting point: all the technology in the world won’t make a difference if it’s not in the hands of an excellent teacher.

The best basketball players in the NBA make millions more than the average ones. The most skilled doctors are rewarded with the highest salaries. Top lawyers earn hundreds (if not thousands) of dollars an hour while one from a third rate law school toils for $65,000 a year in a county prosecutor’s office. So what’s different about teaching? Why do all teachers in a particular district with a particular number of years experience get paid the same salary? Could you ever imagine all the lawyers in a particular city making identical salaries? The idea is absurd. Clearly the top law firms will pay for the top lawyers, which in turn enables that law firm to achieve the best possible results for its clients.

Yet the vast majority of teachers in America find themselves stuck in a system rooted in an outdated belief in equity, egalitarianism, fairness, whatever you want to call it, where pay is based not on talent, ability, skill, expertise, and all the attributes that determine one’s pay in a competitive labor market like medicine, law, and professional sports; rather the older you are and the more time you’ve “served”, the greater your financial reward. Is it a coincidence that America is known for its cutting-edge medical field, its skilled litigators, and world-class professional athletes. Could someone describe to me the reputation of American public schools? No? I understand, it’s a depressing subject.

In economics we teach the importance of incentives, which when used properly encourage individuals to improve their human capital in as many ways as possible. In other words, if I am rewarded for excellence, I will strive for excellence in my profession. The only incentive in education, it seems, is to grow old and gray, because that’s how I will make more money. Easy for teachers whose only goal is to make it to retirement, right? Without a doubt. Effective for students in a society falling ever further behind other countries in academic achievement? Hardly.

Ironically, some of the teachers most skilled in the application of new technologies and versed in the latest pedagogies are those who grew up learning with those technologies in their own education in a constructivist, student-centered environment. In other words, the youngest, most tech-savvy, who just happen to earn the lowest salaries (practically subsistent in some parts of the country).

Mr. Vanderhoek may be proven wrong. Perhaps it is more technology, more standardized tests, more powerful teachers’ unions, that America’s children need to begin achieving the results that Indian, Chinese, Singaporean, Korean, Japanese, even European students are achieving in the maths, sciences, and other subjects. But if he’s right, then $125,000 (2.5 times the national average for public school teachers) may prove to be just what’s needed attract the kinds of teachers that can achieve results. What if this school does succeed? Will it matter? Or will America’s public schools forever reward teachers not for performance and qualifications, but simply for getting older?

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You Are What You Spend - New York Times

Fact: The richest 20% of Americans earn 15 times the income of the bottom 20%.

Fact: The richest 20% of Americans only consumer 4 times as much as the poorest 20%.

Question: Why don’t the richest 20% consume 15 times as much as the poorest 20%?

The author of this NYT opinion piece claims that the gap between America’s rich and poor is not as stark as the income figures suggest. While before tax income of the top 20% is around $150,000, the poorest 20% earn only around $10,000. Clearly these numbers indicate an enormous income gap in America.

However, when it comes to consumption, the poor consume an average of $18,000 on everything from food to housing to entertainment to transportation. The richest 20%, on the other hand, consume an average of only $70,000, less than half their before-tax income.

So the question is, is standard of living based on our income, or on our consumption? If it’s income, then there’s certainly a huge gap in standard of living between the rich and poor. But if we believe it’s consumption, then the gap is narrowed dramatically. The author claims the latter:

To understand why consumption is a better guideline of economic prosperity than income, it helps to consider how our lives have changed. Nearly all American families now have refrigerators, stoves, color TVs, telephones and radios. Air-conditioners, cars, VCRs or DVD players, microwave ovens, washing machines, clothes dryers and cellphones have reached more than 80 percent of households.

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Recently, in AP Economics, we have been learning about Labor markets; in IB Economics we’ve been focusing on the benefits and costs of international trade and global economic integration. As students of market economics, it is ingrained in us that economic liberalization, the freeing of markets, enabling resources to be allocated based on the price mechanism; these are all are good things. Removing barriers to the free movement of products and resources across national and political boundaries should eventually result in greater world output, and subsequently increases in living standards and wealth for the citizens of all free trading countries.

Nations will produce the products for which they have a comparative advantage, and trade with their neighbors for those products for which they don’t. Resources will flow from markets in which they are in low demand to those where they are in high demand. Prices in both product and resource markets will rise and fall, allocating scarce resources to the markets where they are needed most.

So why, in an era where the benefits of free trade and free flow of productive resources seem so visible around the world, do Americans seem so susceptible to views like those exhibited in the video below:

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Shanghai American School Employment - Available Positions

No article here, just some food for though about a meeting all SAS teachers attended today during lunch. Our director, Dennis Larkin, announced the changes being made to teachers’ salary and compensation packages for next school year. As anyone in international education knows, the market for teachers is a very competitive one these days. When I say competitive, I mean schools are forced to compete with one another for a rather scarce supply of teachers who are out there looking for work.

SAS has set as a goal to rank among the top five international schools in Asia with regards to compensation for teachers. It dawned on me during the meeting today that Dr. Larkin’s presentation illustrated a clear example of an imperfectly competitive labor market, the characteristics of which are a few large firms (in this cases schools) competing with one another to attract workers (teachers) to their firm, in order to meet a growing demand for the product being provided (students’ education). In East Asia, where schools all over China, Korea, and Japan continue to grow as more and more employees sent by foreign firms to oversee company operations in the region arrive with their families in tow, demand for more international school seats leads to demand for more international school teachers (remember, resource demand is derived demand). Rising tuition fees (price of the product) cause the marginal revenue product of teachers to increase (remember, MRP = PxMP), and since MRP is synonymous with demand, schools’ demand for labor also increases. Continue Reading »

Foreign Policy: Why We Trade

Professor Russ Roberts, host of the EconTalk podcast, has an essay in the latest issues of Foreign Policy journal titled “Why We Trade”. In this piece, Roberts defends the benefits of trade from a broad perspective, beyond the popular political view of trade, usually along the lines of “exports, good - imports, bad”. Roberts compares this line of thinking (characteristic of presidential candidates of both the Republican and Democratic parties), to the 14th century, pre-Adam Smith view of world trade, known as mercantilism.

Mercantilism was a view of global economic interaction that placed emphasis on the accumulation of gold and other precious metals from abroad in exchange for your country’s exports. The doctrine failed to recognize the importance of imports from abroad, as this was viewed as a loss of wealth to foreigners. Mercantilists viewed wealth in terms of bullion or the amount of precious metals a country owned. Today, of course, our understanding of wealth has evolved to account for the amount of output, or products (goods and services), we are able to consume. Herein lies the flaw in the rhetoric of modern politicians who, “are always talking about the necessity of other countries’ opening their markets to American products. They never mention the virtues of opening U.S. markets to foreign products.”

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Oil worker shortage could lead to supply squeeze - Nov. 2, 2007

Lately I’ve blogged about the impact of higher oil prices on the petrol market in China (here and here). As the main input in petroleum products such as gasoline and diesel, the price of oil affects the costs of fuel producers, such as China’’s SinoPec and PetroChina, the two large state-owned petroleum companies, as well as the scores of smaller competitors in that provide fuel to China’s thirsty economic machine.

As the price of oil has approached $100 per barrel, fuel manufacturers have had to cut back output as their costs have soared, putting upward pressure on the market price of fuel here in China. But what determines the price of a barrel of oil? Is the increase in the price of oil due to an outward shift of demand or an inward shift of supply? Actually, it’s probably both. This article helps answer part of our question, and it does so by discussing one of the determinants of supply of oil, resource costs. Continue Reading »