The following post was written by an AP Economics student at Zurich International School

We all know about market failure on the product side: A good or service is under or over produced in the free market because of externalities that cause the marginal social benefit (MSB) to no longer equal the marginal social cost (MSC). Instead, the good or service is at another equilibrium where the MSB is equal to the marginal private cost (MPC). In such a case, the government may intervene by either taxing or subsidizing the good or service, or even by taking control of production in order to bring the values to the social equilibrium point (MSB=MSC).

Now let’s take a look at how this plays out in the human resources market.

In the human resource market firms tend to pay close to the same salary to people of the same rank or position. This can lead to market failure. An employer might have positive or negative externalities. Their location may be near public transport and in a beautiful location. Or it might be situated right next to a sewage treatment plant. When firms offer the same salary for the same position, their externalities may lead to labor surpluses or shortages, i.e. to market failure.

A firm with negative externalities will have a shortage of workers since the qualified workers can work elsewhere for the same amount. A firm with positive externalities will have a surplus of applicants. The number of people will want to work at such firm will exceed the positions available. The firm could profit from this situation by becoming more selective, accepting only those candidates of superior quality. However, there can also be additional costs to the company if its externalities attract a surplus of applicants. There would be additional costs for processing and reviewing the many applications received. In a world of perfect competition where employee qualifications would be the same, the firm with positive externalities would reduce the wages it offers. This would reduce labor costs and decrease the number of applicants, reducing thus administration costs too. A firm with the negative externalities would have to do the inverse: raise wages in order to increase the number of workers. In reality of course, employee qualifications differ and the firm with positive externalities may get a flood of applications from candidates even those with insufficient qualifications.

There are many examples of positive and negative externalities, not only location. These can range from a positive (or negative) brand to a positive (or negative) reputation in how the company treats employees, such as by having flexible hours or supplying recreational or sporting facilities. When a person is looking for a job, externalities can play a decisive role.

Case Study: John the Consultant

Let us look at John the Consultant as an example. Like most applicants, John is looking for a good salary but he also wants to enjoy his work environment.

John gets three job offers: One from a fairly standard consulting firm, one from a tobacco company, and another from a sports TV network (with great offices with fabulous views).

When he was originally applying, John thought he would jump at opportunity to work at the sports network. The network had been his favorite since he was a child. He loved the thought of working in sports and television.

But then he took a closer look at the actual offers. The sports network offered him a salary that did not even come close to his expectations. The consulting firm’s offer was like its offices: just the standard fare. On the other hand, the tobacco company’s financial offer was mind-blowing.

Why is this so?

The tobacco company’s labor market might look like this:

Here, due to ethical concerns with the product, too few people would be interested in working at the tobacco company if it paid the average wage. Its cost to hire an additional worker (let’s call it the Private Marginal Resource Cost (PMRC)), is higher than the market average (AMRC). This is why it is necessary for the firm to increase wages in order to increase the quantity of labor to the optimal level. To be noticed is that their new quantity of labor is still below the market average. If the firm wanted to raise labor up to the market average, it would have to further increase wages, which would be extremely inefficient since there will be a point at which the cost of the additional workers will outweigh the value they represent.

A sports network company might look like this:

The sports network company, if it offered average wages, would have a surplus of workers. Here the AMRC is higher than the PMRC. In such case, the economically wise action is to decrease wages, thereby decreasing the quantity of labor to the optimal amount. To be noticed again is that its optimal amount is still higher than the market average. If it further decreased wages to reach Q_A there would be a dead weight loss. (Pragmatically speaking, the firm would not hire a surplus of workers; it would stick to Q₂, but even then normal wages would be inefficient, since it could get the exact same quantity of labor at lower wages.)

Now John has the choice of taking less money along with the positive externalities, or more money when there are negative externalities. The externalities turn into opportunity costs. And this creates a dilemma.

Firms have long known the gist of this concept. Most large corporate firms have made serious efforts to increase employee satisfaction in the hope that it will become a positive externality. Yet since the vast majority of employers have done similarly, various types of extra benefits have become standard for the market. However there are still companies that stand out from the rest. For example Google has placed a high priority on creatively generating employee satisfaction and creating a work environment conducive to cooperation and innovation. It has excelled in these domains by so much that their employees are glad to take a lower paycheck than the market average for the privilege of working there.*

Now all this is a prime example of how externalities are corrected through the profit incentive. In contrast to the product market (where a company may not bear the full cost of a negative externality it causes, such as pollution, and government intervention can become necessary), no government interference is usually necessary in the human resource market. There it is the firm that notices and corrects the difference in employee wages in relation to externalities. Most companies have learned to put a price on externalities, and equilibrium is restored.

*As an example, according to the Financial Times Feb 7, 2011, Google now receives an astonishing 75,000 applications a week.

Related posts:

1. Reducing negative externalities – the European market for carbon emissions
2. Shanghai American School and the imperfectly competitive market for international teachers
3. An introduction to consumption externalities from a Singapore perceptive

I have lived in Singapore for two years now and am always interested in the nuances of the city state’s economy. In some measures Singapore has the one of the highest levels of Gross Domestic Product per capita in the world. As measured using Purchasing Power Parity, Singapore is ranked 7th in the world with $53,900 GDP per capita

Singapore also has a high, and growing level of income inequality which has been associated with the form of rapid economic growth. In 2009 Singapore was ranked as having the second highest level of income inequality in developed countries, with a Gini Coefficient score of 0.425. Hong Kong was 1st and USA 3rd. In most rapidly developing economies (China, Brazil, India) strong economic growth is leading to growing income inequality. The gains from growth are not being shared equally between all citizens and the rich continue to get richer at the expense of the poor. Here are some economic indicators from Singapore.

• During 2010 Singapore’s Gross Domestic Product expanded by 14.7%. This is the fastest rate of economic growth in the world.
• Since 1989 it’s GDP per capita has risen from $16,000 to $48,000.
• Total Gross Domestic Product in Singapore Dollars has increased from $56 Billion in 1989 to $265 Billion.
• The bottom 10% of the population now account for only 5% of the national income, compared to the top 10% of people who account for 49% of the income.

Each of the above statistics support the economic goals of Singapore except for the last bullet point. Singapore believes in inclusive growth and attaches a high degree of importance on the ideals of social cohesion. These statistics are a challenge to the goals of the country, which aims to allow all families to live in dignity and with material self sufficiency.

Therefore one possible way to increase the income of the lowest people is to introduce the concept of a minimum wage. Currently the free market determines the market wage. For some occupations such as cleaners, constructions workers and domestic helpers the market is awash which cheap labour from neighbouring countries such as the Philippines, Indonesia, India and Bangladesh. This drives down the market wage. The average domestic live in helper in Singapore would make $120 a week and construction workers slightly more. These workers also have the lowest bargaining power and are often unable to negotiate for higher wages. Thus free market wage seems to disadvantage low income workers in Singapore.

Introducing a Minimum Wage:

The minimum wage is a wage floor. In Singapore, employers would not be allowed to pay their employees a rate below the minimum wage and this presumes the minimum wage was binding and set above the prevailing market rates. Some would call this a living wage and would be set to enable citizens to enjoy a basic standard of life and subsistence.

The negative aspects of the minimum wage legislation would be an increase in unemployment. After the introduction of the minimum wage the market demand for workers would fall to LD. At a higher wage firms have less incentive to hire workers. The other important feature is that Labour Supply would increase at the level of the new minimum wage. More workers would be attracted into the workforce. This therefore creates a disequilibrium where Labour Demand does not equal Labour Supply. In the Labour Market this is known as unemployment. In Singapore potential foreign investors could be less willing to invest in a country with higher labour costs and the nations competitiveness with other economies could fall. After the introduction of minimum wages in Japan (1959), South Korea (1988) and Taiwan (1956) researches found no evidence of a fall in foreign investment or economic competitiveness.

Positive aspects of introducing a minimum wage?

1. To reduce poverty: To help reduce poverty for the bottom 20% of households in Singapore, a binding minimum wage set above the market wage would lift incomes. The lifting of incomes should also reduce the level of income inequality for low income households.
2. Taxes and Benefits: If workers begin to earn higher wages then tax receipts should increase. At the same time the level of financial support for such families will likely fall as they become more self sufficient. This could also help reduce government spending. Both of these effect will likely have a positive impact on the government budget.
3. The effect on worker productivity: Some economists believe that the increased wage might improve labour productivity. Workers may respond to their higher wage rate by working harder, possibly as a result of worrying about losing their job now that the increased wage rate has made it a more ‘sought after’ job. Employers may force through productivity improvements. Some workers will work shorter hours and achieve a greater work life balance and hopefully be more productive during these hours at work.

Market interventions are obvouisly not the only way to improve the incomes of low income households. Singapore currently does many small things to improve the quality of life for low income households. In my opinion in the long run the economy needs to think of other ways to increase incomes of low income households so that Singapore holds the value of social cohesion and does not become a infamous country of unequal incomes and  extremes of wealth and poverty.

• Subsidized Housing and Grants for first home buyers – HDB Scheme
• Free education from Kindergarten to Secondary School.
• Subsidized health care
• Various financial assistance schemes including the Workfare Income Supplement

Resources and Background :

• Minimum Wage Theory – S-Cool UK | Economics
• “Don’t knock the minimum wage yet” | Tommy Tan – see commentary here (The Straits Times, A32, November 11th 2010)
• CIA Factbook | Singapore Overview

Discussion Questions:

1. Describe the kind of tax system which could be developed to reduce income inequality?
2. Outline the difference between income and wealth?
3. What is the more concerning problem for governments, the inequality of wealth or income? Explain.
4. Evaluate the methods available to government to reduce income inequality.

Related posts:

1. Income inequality as a Market Failure
2. The role of taxes in income re-distribution – another preview of my textbook
3. Recession’s effects on small vs. large companies: some evidence in support of the Classical view of self-correction

Related posts:

1. America’s Immigration Problem – the human cost
2. Immigration and American labor markets – opposing views
3. America: Land of the free, home of “jackass” economists

Next Test – Value of $125,000-a-Year Teachers – NYTimes.com

A New York City charter school is experimenting with paying teachers nearly triple the national average teacher salary of public schools. The article below describes the result:

So what kind of teachers could a school get if it paid them $125,000 a year?

An accomplished violist who infuses her music lessons with the neuroscience of why one needs to practice, and creatively worded instructions like, “Pass the melody gently, as if it were a bowl of Jell-O!”

A self-described “explorer” from Arizona who spent three decades honing her craft at public, private, urban and rural schools.

Two with Ivy League degrees. And Joe Carbone, a phys ed teacher, who has the most unusual résumé of the bunch, having worked as Kobe Bryant’s personal trainer.

“Developed Kobe from 185 lbs. to 225 lbs. of pure muscle over eight years,” it reads.

They are members of an eight-teacher dream team, lured to an innovative charter school that will open in Washington Heights in September with salaries that would make most teachers drop their chalk and swoon; $125,000 is nearly twice as much as the average New York City public school teacher earns, and about two and a half times as much as the national average for teacher salaries. They also will be eligible for bonuses, based on schoolwide performance, of up to $25,000 in the second year…

The school received 600 applications. Mr. Vanderhoek interviewed 100 in person.

It’s amazing to me that a school in NYC that pays $125,000 a year and expects teachers to work year round gets so much attention, while some international schools have been paying teachers nearly as much for decades to work a regular school year. Yet so many American teachers seem unaware of the career opportunities available at international schools! A salary of $100,000 is not unheard of in international schools, and often times that income is tax free (at least the majority of it, since it is considered “foreign earned income” by the IRS).

In economics we study how scarce resources are allocated by supply and demand in the market place. Demand for highly skilled, qualified teachers is huge in all kinds of schools, public, private, charter and international schools alike. But only once an American school like this New York charter school comes along and offers to pay teachers a salary more than double the national average (and then receives nearly a hundred applications for every opening) do we begin to read about teacher pay in the news and reflect on the roll it plays in attracting top notch, expert educators. From one economics teacher’s perspective, it should come as no surprise at all that when a school offers a higher salary it will attract better teachers and thereby improve the quality of the education it provides.

International schools have known this simple fact for years. Unlike the American public school system, which from state to state essentially resembles the “monopsonistic employer” model (meaning each state has a “monopoly” of sorts on the hiring of teachers), the market for international teachers is highly competitive. In most big cities, even, there are several international schools competing to attract the best educators from the limited supply available. And in a particular country, for instance China, there are dozens of private international schools, all seeking to offer the best quality education in order to increase demand for enrollment, competing against one another to hire the best teachers they can.

The result of the competition between international schools for student enrollment is increased competition for skilled, qualified teachers. Add to this the fact that year after year there end up being shortages of qualified international teachers and you end up with the perfect recipe for teachers like myself and all the colleagues I’ve worked with over the years, upward pressure on the salaries and benefits packages offered by international schools.

The lesson here is clear from my perspective. Increased competition among schools for student enrollment will lead to increased competition among schools for better teachers, and therefore better teacher pay. The NYC charter school set out with a clear vision in mind for achieving students success. Attract the best teachers and we’ll provide the best education. And in order to achieve this vision, it followed the most basic of economic principles, articulated so eloquently by Adam Smith himself:

Whoever offers to another a bargain of any kind, proposes to do this: Give me that which I want, and you shall have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of.

The bargain being offered to teachers in this case is an attractive salary, and all the schools in question are asking for in return is excellent teaching. “In this manner” schools obtain from teachers a commitment to excellence and teachers obtain from schools a salary that rewards them for this commitment. Society’s need for excellent education and teachers’ need for a living wage are met. But public schools go against this basic tenet of  market doctrine when the monoposony that is the state public school system pays teachers not based on their achievement, training, excellence or results but on their years of service. The lack of competition for student enrollment leads to a failure of the incentive system for attracting good teaches, and what schools find themselves with is a burnt out, underpaid, disgruntled work force and test scores and student achievement that you’d expect to follow.

I hope this charter school succeeds. I hope the students’ scores surpass those of their public school peers. I hope this not  because I like to see the old model of education fail, but because I would love to see a new model, based on the simple market principle that individuals respond to monetary incentives, succeed. I can say from experience that the competition among international schools for the limited supply of skilled teachers benefits all the stakeholders in question: teachers are paid better, the schools that pay the most attract the best teachers and thereby attract the greatest demand for enrollment. The market has worked! If the New York charter school succeeds, how can this be ignored. How can America’s other public schools not admit that to improve education, competition for students and teachers must be embraced.

Related posts:

1. Shanghai American School and the imperfectly competitive market for international teachers
2. If you pay them, they will come: teacher pay, incentives, and results
3. New tools for the Econ teacher and student: Social bookmarking Site, iPhone App and YouTube Review Videos

Fidelity Investments – Inflation: A Threat or Not? by Dirk Hofschire

I was surprised to receive an email from the company that manages my personal investments directing me to an article that I would be able to use in class. But this analysis by a vice president of Fidelity Investments offers and excellent, concise examination of the threat posed by inflation in America today. I will use excerpts from the article and present the ideas in a graphical form to help students better understand the situation faced by the US as it struggles to emerge from its deep recession.

Hofschire sets out to answer four questions about inflation:

1. Is inflation accelerating?
2. Why is higher inflation expected?
3. Why hasn’t inflation occurred yet?
4. When will inflation return?
5. How high will inflation go?

1. Is in flation accellerating:

In short, NO.

In June, the U.S. consumer price index (CPI) declined 1.2% (on a year-over-year basis), representing the biggest fall in prices since 1950.1 Much of the decline is attributable to the steep drop in energy prices over the past year, which may reverse itself in the second half of 2009 if crude-oil prices remain near current levels. However, core CPI—which excludes food and energy—was less than 1.8% in June, demonstrating little inflationary pressure in general

A combination of weak aggregate demand and low resource costs for firms has kept price levels down.  While total spending has falling (leftward shift of AD), firms’ costs of production have fallen (rightward shift of AS). Since total output fell we can see that national income (Y) is less in 2009 than in 2008. Since price level has fallen, we can see deflation.

Diagram 1:

2. Why is higher inflation expected?

With little evidence of economic strength or cost-push inflation today, the concern now is that the monetarist economic view of the world sees inflation clouds on the horizon. The godfather of modern monetarist economic thought, Milton Friedman, once stated, “Inflation is always and everywhere a monetary phenomenon.” What Friedman meant was that money—specifically changes in the supply and use of currency—was the primary driver for changes to price levels in an economy. Friedman informally defined inflation as “too much money chasing too few goods and services.” As a result, an excessive increase in the amount or use of money relative to economic output is the textbook prescription for inflation.

The inflation described above, and feared by Friedman and today’s monetarists is not of the cost-push type, rather the demand-pull variety. As the vast quantities of money injected by the US Fed work their way through the banking system and into the pockets of consumers and the hands of firm managers, eventually demand for America’s goods and services will rise. But in the current recession, the production of those goods and services has stagnated, meaning that once all this money starts getting spent, the competition among buyers for the limited output of producers will drive prices up.

Diagram 2:

3. Why hasn’t inflation occurred yet?

…there remains considerable downward pressure on prices still in place, due to growing slack in the economy (i.e. underutilized resources, such as labor) and continued deleveraging by consumers and financial firms with heavy debt loads. With the unemployment rate at its highest level in 26 years and consumers saving more and spending less, there is little upward pressure on wages or prices for consumer goods.

Yes, the money supply has increased, which according to our answer to number 2 should lead to inflation. But not if the new money isn’t being spent! Banks with money from the Fed are holding onto their excess reserves instead of loaning them out, due to a prevailing lack of confidence in borrowers ability to repay loans during these hard economic times. If all the money the Central Bank is injecting in the economy is sitting idle, and resources such as labor, land and capital are under-employed, then there is little fear of cost-push nor demand-pull inflation.  Diagram 1 illustrates why inflation hasn’t occured yet.

The excess bank reserves thus represent both the potential for future inflation as well as the explanation for why rapid money growth has yet to create current inflation.

In short, money must be spent to drive inflation up. When households prefer savings to consumption and banks prefer liquidity to risk, inflation is only a distant fear.

4. When will inflation return?

Interestingly, the answer to this question can be summed up as: “hopefully sooner rather than later”. Despite popular belief, some inflation is considered a positive sign of economic growth. Just as deflation is the purveyor of doom and gloom (unemployment, uncertainty, low consumer and investor confidence, credit crunch, etc) inflation is a sign of health returning to the economy (improved confidence, rising employment, looser credit markets, expectations of future growth). Central Bankers like Bernanke will surely be showered with praise, while congressman will be quick to give credit to the fiscal stimulus package.

Whether the pick-up in money velocity leads to significantly higher inflation depends on how quickly the Fed pulls the reins back on the extraordinary credit it is currently providing. In theory, the Fed can take actions to reduce the size of its balance sheet and move back to a more appropriate level of money. In practice, due to the unprecedented expansion in the Fed’s balance sheet, this will be a challenge.

Just as it was the Fed”s and government’s job to get the party started through expansionary monetary and fiscal policies, it is equally important for policymakers to calm the party down should the level of inflation begin to rise.

Diagram 3:

5. How high will inflation go?

Given the high level of slack (i.e. underutilized resources) likely to remain in the economy during the next two years, there also could be offsetting deflationary pressures lingering in the system. For example, the unemployment rate is expected to rise above 10% and not peak until sometime in 2010. Industrial capacity utilization rates are at their lowest level on record, which means a lot of unused capacity in the manufacturing sector. This slack must tighten considerably before upward pressure is placed on wages and other prices.

As a result of this downward pressure on wages, which remain the largest expense for corporations, it would appear a 1970s-style, double-digit inflation outburst remains unlikely in the short to medium term. Average weekly earnings for U.S. workers rose more than 7% annually during the period from 1975-1981 in which consumer price inflation averaged more than 9% and peaked at 14% in 1980.5 It is hard to foresee wage gains of that magnitude reinforcing inflation pressures during the next couple of years.

The 1970′s was a period of high inflation in the US, caused primarily by higher costs for firms rather than increasing demand for output. This “cost-push” inflation is unlikely to occur in today’s climate due to the high levels of unemployment and under-employment of labor, land and capital resources. This does not mean inflation won’t happen, just that it’s unlikely to look like the cost-push variety of the 1970′s.

Diagram 4:

Related posts:

1. Unemployment and inflation: understanding the Fed’s balancing act
2. Will the Fed’s easy money policy fuel global inflation?
3. The true causes of and solutions to inflation in China

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?

Related posts:

1. Doom and gloom in the headlines as US economy teters on edge of recession…
2. Does free trade really mean lower prices? A debate between two economists much smarter than me
3. Stagflation – a blast from the past could mean trouble for US economy

Help Wanted: Why That Sign’s Bad – BusinessWeek

This week’s cover story in Business Week magazine tells an interesting story about unemployment in America. Listen to the podcast or follow the link above to read more of this story:

Surprising statistic: In the midst of the worst recession in a generation or more, with 13 million people unemployed, there are approximately 3 million jobs that employers are actively recruiting for but so far have been unable to fill. That’s more job openings than the entire population of Mississippi.

Sound like good news? It’s not. Instead, it’s evidence of an emerging structural shift in the U.S. economy that has created serious mismatches between workers and employers. People thrown out of shrinking sectors such as construction, finance, and retail lack the skills and training for openings in growing fields including education, accounting, health care, and government. At the same time, the worst housing bust in decades has left the unemployed frozen in place. They can’t move to get work because they can’t sell their homes.

In IB and AP Economics we teach that there are three types of unemployment an economy may experience, ranked roughly in order from the least undesirable to the most undesirable (from a macroeconomic perspective):

• Frictional unemployment: This accounts for people who are “in between jobs” or fresh out of college looking for their first jobs.
• Structural unemployment: This is caused by the changing structure of an economy. As America’s manufacturing sector shrinks and its education and health care sectors grown, those whose skills lie in manufacturing become structurally unemployed.
• Cyclical unemployment: This is also called “demand-deficient” unemployment because it is caused by a fall in aggregate demand or overall spending in the economy.

America today is clearly experiencing all three types, but due to the particular circumstances of the recession, the American worker is finding it it harder than ever to match his skills with an appropriate job. Below are some of the industries with the most and the fewest job openings today:

Most openings:

• Education
• Health care
• Government
• Energy (such as wind, oil, natural gas)
• “Analytics” (i.e. business data analysis by firms such as IBM)

Fewest openings:

• Construction
• Manufacturing

Unfortunately for the large numbers of unemployed construction and factory workers, the kinds of skills required to work in the fields with the most job openings are prohibitively different from those learned in their previous industries. In addition to a mismatch of skills between the industries in which jobs are being lost and those in which labor is in demand, there is also a geographic mismatch in the labor market. Below are the states with the least and the most job openings:

Most job vacancies (states with large energy sectors: oil, natural gas and windmills)

• North Dakota
• Wyoming

Least job vacancies (states with large manufacturing and construction sectors)

• North Carolina
• California
• Michigan

Historically, the geographic factor has not posed an issue to American workers, and when jobs opened up in one part of the country, Americans would pack up and move where necessary to find work. Today, however, with the collapse of house prices, more and more Americans find themselves stuck with a house they can’t sell in a part of the country where they can’t find a job.

To paraphrase the podcast above, “the US in danger of looking like Europe. The European job market has been described as ‘sclerotic’; people don’t respond to want ads because of the generous long-term unemployment benefits offered by European governments. Europeans have historically been geographically immobile due to nationalist ties to their home countries.” Today, the US job market reflects some of the same “sclerosis” as that of Europe.

America is facing the perfect storm of unemployment. At the same time that the economy is undergoing its most significant structural change since the Industrial Revolution brought millions of American workers from the farm fields into factories, it is facing the most significant decline in private sector spending (consumption, investment and exports) since the great depression. Put this together with the relative immobility of the American worker caused by the housing crisis, and unemployment has climbed to its highest level in three decades.

This interesting story ends with a glimmer of hope for the American worker:

To fight this sclerosis, the White House is using $3.5 billion of the stimulus for training, while boosting support for community colleges. Classes for factory workers seeking entry-level health-care careers have shown some success.

The truth is, displaced workers may have to move down a few rungs as they switch careers because their skills are irrelevant in their new roles… Many laid-off Wall Street financial engineers still haven’t absorbed that, says Fred Wilson, a partner in Union Square Ventures, a New York venture capital firm. “For them to take a job that pays a lot less, they have to make a meaningful change in their lifestyle. And that is an issue.”

Employers need to bend as well, recognizing that the candidates they’re seeking may not exist. Mark Mehler, co-founder of CareerXRoads, a staffing strategy consulting firm in Kendall Park, N.J., tells employers: “You’re hiring potential….You’ve got to train them.”

A mismatch of work and workers is never a good thing. But smart policy—combined with realism on the part of employers and job seekers—can minimize the disruption.

Discussion Questions:

1. In what way may structural unemployment be a sign of a healthy economy, rather than a sick one?
2. Part of the Obama stimulus package includes increased benefits for unemployed Americans. How may this pose an obstacle to reducing unemployment in America?
3. Historically, the natural rate of unemployment in most European economies has been higher than that of the United States. Why is this?
4. Do you think America’s NRU will return to its historic level (4-6%) when the economy eventually recovers from the current crisis? Why or why not?

Related posts:

1. Some good news for Swiss businesses and workers during hard economic times
2. Exports, good – Imports, ALSO GOOD!
3. Will the economy self-correct?

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

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

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

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

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

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

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

Related posts:

1. McJobs in America – under threat!
2. America: Land of the free, home of “jackass” economists
3. Private Market Compensation: AIG CEO vs. Kobe Bryant

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?

Related posts:

1. IB Review – Neo-classical vs. Keynesian views of inflation
2. Facts and the Phillips Curve: new evidence of the short-run trade-off between unemployment and inflation
3. Keynesian/Classical debate enters the realm of hip hop

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

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

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

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

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

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

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

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

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

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

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

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

Related posts:

1. Stagflation – a blast from the past could mean trouble for US economy
2. Deflation: why lower prices spell doom for any economy!
3. Recession’s effects on small vs. large companies: some evidence in support of the Classical view of self-correction

“Anger”, more so than “fear”, is perhaps the most often expressed emotion by U.S. citizens, Congressmen, and media analysts when discussing the proposed $700B federal bailout of the U.S. financial system. “Anger” is the primary emotion because the $700B will be put at risk by the American taxpayer to bailout the very same financial institutions that have become increasingly reckless and greedy regarding their investing and borrowing practices.

In America, especially over the last two weeks, the discussion of a bailout to save our financial system and economy from ruin has become logically intertwined with a concurrent discussion of Chief Executive Officer (CEO) compensation packages. Many are outrgaged, especially in light of the horrendous financial results and excessive risk taking, when finding out about the lucrative CEO compensation packages consisting of base pay, bonuses, stock options, and termination (severence) pay.

Let’s analyze this topic by comparing the compensation packages of basketball superstar Kobe Bryant and recently fired AIG CEO Martin Sullivan.

In 2007, Kobe Bryant earned $20 million dollars playing basketball for the Los Angeles Lakers while Martin Sullivan earned $14 million dollars in 2007 running AIG, one of the largest insurance companies in the world.

In 2006, Bryant also earned $20 million for the year, whereas Sullivan earned $27 million as AIG’s financial performance was much stronger in 2006 versus 2007, causing Sullivan’s 2006 incentive-based compensation to be higher than 2007.

Now the big one: Sullivan’s 2008 termination or severence pay upon his firing as AIG CEO was $47 million dollars (two years pay)! Pretty nice “goodbye present” for Sullivan given the fact that AIG failed causing its owners (the stockholders) and potentially our country (taxpayers via bailout) to be crushed! Although Bryant has no termination or severence bonus built into his contract, his contract is guaranteed through 2011 which is somewhat similar to Sullivan’s “severence deal” in that Bryant is guaranteed payment should he be injured.

Thus, both compensation packages (Bryant and Sullivan) are somewhat similar in dollar amount, but beg the question: Is anyone worth that much money?

So the primary question of this blog is to discuss whether private market compensation, should be somewhat controlled or limited by governmental law, and if so, how.

Let’s start with Bryant.

If we passed a law taking the position that Bryant’s salary could not exceed $5 million per year, he would likely go play in Europe where European contracts are becoming more competitive and similar to U.S. contracts. Even if Bryant did stay with the Lakers, despite the new law, at $5 million per year, the $5 million savings (reduced salary) would go to the Lakers owner, Jerry Buss, so Buss would be making $5 million more at Bryant’s expense. In summary, we would have passed a compensation limiting law taking money from Bryant and giving it to the owner! Through the study of economics we ultimately understand that Bryant is, in essence, being paid by you and I whenever we see him at the arena (ticket prices) or watch him on TV (ad revenues). Ultimately, Bryant gets $20 million because we, not Buss, pay him $20 million! This is the private market at work, where voluntarily owners (Buss) pay their employees (Bryant) what they believe they are worth. Said one last way, Buss pays Bryant $20 Million per year because Buss thinks he can make more profit than if he doesn’t and loses Bryant to another team.

Let’s go to Sullivan now.

If we passed a law limiting executive salaries to some arbitrary number, say $5 million per year, the same thing would happen that happened to Bryant. The Harvard & Yale MBAs would not pursue American companies but would go to work at Canadian, European and Asian companies whose compensation would be “free market”. The U.S. would lose its best talent and our companies would become mediocre, fail at an increasing rate, and our standard of living would deteriorate as our leadership quality would deteriorate. It is the CEO that is at the helm of companies helping American businesses to produce an average 10.4% return for their owners (stockholders).

Now we get to the toughest question which is “should CEOs be paid a multi-million dollar severence payment after they have failed and been fired?” The obvious answer seems to be no! But sometimes, what appears to seem to be the obvious answer becomes less obvious in a free market. Any smart, Harvard or Yale MBA knows that they have a 50/50 chance of failing and being fired within their first 3 years as CEO. Statistics bear this out as CEOs are fired all the time as it is easier to fire the CEO than all of the employees. Large firms need the best talent and a talented CEO knows that sometimes their companies fail quickly often for reasons beyond their control no matter how talented they are. Thus, CEOs demand an “insurance payment” called severence pay to compensate them for their high risk and rate of failure. Once the CEO fails it becomes increasingly difficult to get that next CEO job as their reputation in the market place sours. Thus, a CEO looks at the entire compensation package (salary, incentives, and severence) when deciding where to work. If the risk is too high (dedicating their life to their business in lieu of their families) relative to the reward, they will take their talents elsewhere or to a new career.

What is my suggested government solution regarding trying to protect shareholders from excessive executive compensation? I suggest that our government only pass new law to increase ”disclosure requirements” on executive compensation to provide a better ”check and balance” on the Board of Directors who set the pay and severence amounts for the CEOs. The Government (SEC) should not get involved, in my opinion, with compensation limits or restrictions on severence pay, but they should pass a new law to provide greater visibility for the owners (stockholders) on their CEO’s (and other key management) compensation. For example, even though today all executive compensation is publicly accessible by the owners by examining publicly filed documents, the Government could pass new legislation making it mandatory for companies to send an annual letter directly to its owners (stockholders) outlining only their CEO’s and Board’s compensation.

But , please Government, be careful and don’t do anything stupid like setting maximums for CEO compensation.

Discussion Questions:

1. In your opinion, should the Government limit CEO salaries to some maximum? What about their severence payments, should they be limited? If so, how would you set the maximum amount?
2. Is it fair that Kobe Bryant makes more than a police offer? Why or why not?
3. What specific action should the Government take, if any, regarding executive compensation?

Related posts:

1. Will limiting exectutive pay send American business leaders packing for Europe? Probably not…
2. Obama’s carbon market: an introduction the market-based approaches to pollution reduction
3. From public to private – what’s next, lighthouses?

CHICAGO, January 7, 2008 – How much money does it take to be considered rich?  It turns out that $1 million just doesn’t cut it, anymore.

In fact, rich today requires at least $5 million, according to a new survey of affluent households, defined as those with investable assets of $500,000 or more.  When asked how much money it takes to be rich, 45% chose $5 million, 25% selected $25 million, and 8% picked $100 million, according to the research by Millionaire Corner (http://www.millionairecorner.com/index.php), a newly launched website powered by Spectrem Group.  Only 22% said $1 million is enough to be rich.

 Achieving such wealth – and holding onto it for generations – is the topic of a new book by Spectrem’s Catherine S. McBreen and George H. Walper, Jr. titled “Get Rich, Stay Rich, Pass It On: The Wealth Accumulation Secrets of America’s Richest Families” (http://getrichstayrich.net/).  Published this month by Portfolio and available in bookstores now, the book is based on years of research in addition to interviews with ordinary individuals who were able to amass enough wealth to pass on to future generations. “All you really need is to know how to use the same wealth-building tools Carnegie and du Pont and all the other progenitors of sustainable fortunes used,” McBreen and Walper write.  “They created the model but they didn’t patent it.  It’s available for your use, and this book is the operating manual.” 

The authors found that the proper mix of entrepreneurial activities and income-producing real estate is the key to achieving building perpetual wealth. “Get Rich, Stay Rich, Pass It On” walks readers through not only the theory but the practice of building sustainable fortunes.  It not only lays out the model, but provides exercises to help readers bring their own finances into focus and determine what they need to do to develop perpetual wealth of their own.

 

* * *

 The data on how much it takes to be rich are based on 253 telephone interviews conducted in December 2007, with a margin of error of plus or minus 6.2 percentage points.  Interviews were conducted with the financial decision-makers in households with $500,000 or more in investable assets. 

Related posts:

1. Is Switzerland becoming a feudal state?
2. A macroeconomic mystery – the gap between America’s “rich” and “poor”
3. Tax progressivity in the US: Do the rich pay more than their fair share? The evidence indicates NO!

U.S. companies are rethinking manufacturing in China – Sep. 11, 2008

As the US presidential campaign trudges ever forward, both Obama and McCain have had much to say about “job creation” in the USA. Elaborate plans aimed at retraining workers displaced by globalization, arming them with 21st century skills that will enable them to thrive in our advanced economy, and assure that the hardships imposed by free trade are minimal and all Americans have the skills they need to find employment. These are good goals for America, but even as they preach their job creation plans across the country, right under the candidates’ noses jobs are being created thanks to the invisible hand of the market economy.

Talk of a reverse migration of manufacturing from China to the U.S. has been buzzing across union halls and factory floors, corporate boardrooms and Wall Street.

The cost of shipping outsourced goods from China to U.S. customers has doubled in just two years thanks to high oil prices, and labor costs in China are rising sharply.

“There’s a shortage of technical and managerial talent,” reports Anand Sharma, CEO of TBM Consulting Group. “To attract managers Chinese companies are talking about salary increases of 15% to 30% year-over-year.”

The phenomenon of jobs being “in-sourced” to America after a decade or two of being done by Chinese workers may seem surprising. Certainly, wages are still lower in China than in the US labor market. This is true, however, the demand for highly skilled labor in China is driving wages up higher and higher, due to its relative scarcity in a country where reliable, well-educated factory managers are nearly fully employed by the thousands of foreign and Chinese firms operating plants there. Competition among producers means the only way to attract new managers is to continually offer higher wages. This leads to a form of “wage-spiral inflation” where rising costs lead to higher priced output.

Despite its much smaller work force, the percentage of American workers with the managerial and technical skills needed to run a plant is much higher than in China, and the weak manufacturing sector growth in the US has meant relative wages between the US and China are closer than ever before.

Take into consideration the rising cost of fuel and the fact that China’s economy is producing at or beyond full employment, and it becomes clear why manufacturing certain products in China has become less attractive to American firms. To be sure, not all manufacturing jobs are being “in-sourced” back to the US. As Chinese wages climb and skilled labor becomes more scarce, the giant’s Asian neighbors are beginning to enjoy the re-allocative effects of the “invisible hand”.

…plenty of manufacturers will continue looking for ever cheaper places to produce. In fact, as the cost of doing business in China rises, many companies – including Chinese firms – are shifting their production to less expensive markets, such as Vietnam.

Discussion questions:

1. What is the “invisible hand” referred to in the post above?
2. How do higher wages in China benefit Americans? How do they harm Americans?
3. Some critics of free trade argue that multi-national corporations exploit workers in developing countries. Does the article above illustrate give an example of exploitation? Discuss…

Related posts:

1. China makes, the world takes
2. Does the weak dollar help US manufacturers?
3. China: formerly the world’s factory, now a nation of consumers…

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?

Related posts:

1. Unemployment and inflation: understanding the Fed’s balancing act
2. Doom and gloom in the headlines as US economy teters on edge of recession…
3. Stagflation – a blast from the past could mean trouble for US economy

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:

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?

Related posts:

1. Reflections on the weak dollar
2. The dollar’s weak… no, wait, it’s strong!
3. What’s got the dollar so weak in the knees?