Plain Sense Economics

Flag of Turkey

In my summer Principles of Macroeconomics class we’ve been discussing the reasons why China has surged to be such a strong economic power.

In an article in The New York Times, Turkey is described as another surprising country showing remarkable growth.

Today, Turkey is a fast-rising economic power, with a core of internationally competitive companies turning the youthful nation into an entrepreneurial hub, tapping cash-rich export markets in Russia and the Middle East while attracting billions of investment dollars in return.

It’s interesting to speculate on the reasons for this economic growth. The article speaks about the policies of Prime Minister Erdogan – socially conservative but pragmatic. My guess (and it is just a guess) is that Turkey made it much easier for foreign investment dollars to flow into the country.

[Reminder to my students: investment capital is a classic scarce resource that countries cherish. They can gather it by selling exports or attracting foreign investments or by national savings. Whatever way it comes, capital allows a country to make investments in productivity, market formation, and more.]

There is a dark side to foreign investment, and that is a potential loss of control of a country’s key assets to foreign management and investors. Many countries fear this loss of economic sovereignty and put up significant barriers to foreign investment. There are many examples, particularly in mining and other natural resource extraction, where the foreign companies reap large profits, with only token royalty payments to the home country.

There can be other ingredients for economic success, including a government and legal system that protects property rights and encourages investment – whether domestic or foreign. Turkey will be interesting to watch.

A recent news article announced the discovery of significant mineral deposits in Afghanistan.

The United States has discovered nearly $1 trillion in untapped mineral deposits in Afghanistan, far beyond any previously known reserves and enough to fundamentally alter the Afghan economy and perhaps the Afghan war itself, according to senior American government officials.

The previously unknown deposits — including huge veins of iron, copper, cobalt, gold and critical industrial metals like lithium — are so big and include so many minerals that are essential to modern industry that Afghanistan could eventually be transformed into one of the most important mining centers in the world, the United States officials believe. (Source: New York Times, June 13, 2010)

This is a good opportunity to review the core economic concepts of scarce resources and production possibilities. Classical economics starts with the idea that resources which can make us happy, or make our nations thrive are scarce – there are not enough resources to satisfy all of our needs. Going from here, classical economics studies how people and nations make decisions on the allocation/use of those scarce resources.

Afghanistan is a desperately poor nation – with a GDP of $800 per capita; compared to $46,400 for the U.S. (Source: CIA World Factbook). Much of this is due to decades of war and conflict within its borders. It must allocate a small number of scarce resources to a variety of outputs. Just two of these many outputs might be food production (necessary for health and a standard of living) and textiles (necessary as an export good).

Before and After the Discovery of Mineral Deposits

We use a production possibility curve to illustrate the decisions on how to allocate scarce resources between two outputs. Consider this sample graph.

We choose two outputs – food and textiles – and place one on each axis. The points where the curve touches an axis represent the theoretical output if all scarce resources were devoted to that single output. More realistically, the curve represents various combinations of outputs, based on allocating those scarce resources between the two outputs. If the country operates on its production possibility curve, it is using all of its resources efficiently. If it operates below the curve, some scarce resources are not being used.

Now, all of a sudden, Afghanistan discovers that it has these vast reserves of precious minerals. The possibilities in their economy will improve. The production possibility curve will shift out and to the right. The challenge for this country hobbled by poor transportation networks, corruption in government, and active hostilities within its borders is to reach this new production possibility.

Jasen Hartford, a friend and past student, recently asked me,

As we all know, the European Union has recently been under the lime light with their budget deficit problem – causing a lot of anxiety for investors in the U.S. I’m curious if there’s a reason why the even greater deficit in U.S. isn’t being publicized as much?

Crumbling Parthenon

The quick and honest answer is that I don’t have any special insights into the minds and souls of investors – not being one myself. Still, there are some characteristics of the European economic crisis that are different from the United States, but can provide cautionary tales for our own economic policy.

As of today the US national debt stands at $12,988 billion (that’s almost $13 trillion). In 2009 our Gross Domestic Product was $14,256 billion. So our debt is about 91% of GDP.  From news sources Greece has debt of around $368 billion, and a 2009 GDP of $357 billion – a debt load of 103%. So somewhat higher than the US but not by multiples.

So, just to repeat my earlier disclaimer – I don’t know what makes international investors tick. Here, though, are some of my concerns about Greece and Europe, and what distinguishes them from the U.S.

Greece is a member of the Euro community – i.e. they no longer have their own currency, but use the Euro instead. This should provide stability in foreign exchange markets, compared with maintaining their own currency. On the other hand, Greece no longer has sovereign control over its own monetary policy. The Euro central bank can change the supply of euros, and the Euro community in general impacts the value of the euro on the foreign exchange market. In sort Greece is dependent on others to apply some traditional rescue strategies. What Greece has in common with the United States is the need to balance government revenues and government expenses in the long run.

The concern about Greece seems to be bigger than Greece. Policy makers and observers worry about other country members of the euro community, including Spain and Portugal. They see a domino effect that threatens most of Europe. For the U.S. that means worrying about some of our best customers and understanding that the global financial structure is interdependent, with a credit crisis in Europe spreading here quickly.

I also think confidence in the central banking and political system plays a role in investor perception. We’re quick to criticize both the Federal Reserve and Congress for their actions or inactions. The world has a more sanguine view of these institutions, though. The value of the U.S. dollar has been rising in recent weeks, as investors switch to dollar-denominated securities – in particular U.S. treasury bonds. Those investors have more confidence in the U.S. than in Europe – for better or for worse.

None of this means that the U.S. debt situation is nothing to worry about. While I may not be confident in the economic policy process in Congress, I do have faith in the Federal Reserve. And in contrast to the deficit hawks I believe we still need to be spending government money to stimulate our recovery.

This is why economists sometimes have a bad reputation (in addition to forecasting 9 of the last 5 recessions…) This op-ed piece in the Boston Globe poses a question on whether sellers should raise prices in times of acute demand – i.e. price gouging. The straight up economic answer is that gouging should be allowed. From the piece…

It never fails. No sooner does some calamity trigger an urgent need for basic resources than self-righteous voices are raised to denounce the amazingly efficient system that stimulates suppliers to speed those resources to the people who need them. That system is the free market’s price mechanism — the fluctuation of prices because of changes in supply and demand.

Thank you to Anya Quinn on Flickr for the use of this image.

We all reflexively abhor an opportunist, who raises prices on a critical item just when it is needed the most. Yet, pricing is what allows society and its members to make thoughtful judgements on the best use of scarce resources. Read through the article, and ponder a bit.

P.S. – My friend, Melanie, writes PrattleNog, and her blog just got a day’s worth of fame on the WordPress home page. She teaches and works with adult students at Marylhurst University and sometimes teaches a course on Social Media. I noticed that she has been scrupulous about crediting the source of her images, and properly chastened I vowed to emulate her. This particular image is made available for sharing under the Creative Commons licensing site/movement. I’m including the official attribution below, but if you are interested in the whole digital copyright brawl, follow the CC link for more information.

Esther Duflo teaches economics at MIT, and is this year’s recipient of the John Bates Clark medal to an American economist under the age of 40 who is judged to have made the most significant contribution to economic thought and knowledge. From an MIT web site:

Duflo, a 37-year-old native of France, is the Abdul Latif Jameel Professor of Poverty Alleviation and Development Economics at MIT and a director of MIT’s Abdul Latif Jameel Poverty Action Lab (J-PAL). Her work uses randomized field experiments to identify highly specific programs that can alleviate poverty, ranging from low-cost medical treatments to innovative education programs.

Watch her talk at a recent TED conference, for a convincing story that simple economic theory, backed by controlled field experiments, can yield important changes in our world.

N. Gregory Mankiw posted a semi-tongue-in-cheek note on his blog suggesting that we consider a system where email senders pay to send a message. One of Mankiw’s readers opined…

I think an excellent Pigouvian tax would be a tax on emails. Many emails involve a negative externality (I don’t really want to receive them) and almost all the ones I really want to get are worth much more than a penny or so to the sender. So a penny tax (say) on email would probably generate large amounts of revenue, mitigate an important negative externality, and have minimal inefficient disincentives. Since email servers are necessarily centralized and networked and all email senders are ipso facto connected to an ISP who is charging them for access the transactions costs and evasion problems seem low.

As a reminder, a Pigovian tax is one that is levied to change market behavior – typically to address a market failure like externalities or to prevent over consumption of a common good.  Mankiw extends the idea, hoping that the recipient could set the price. If someone wanted to seriously reduce the email they received – limiting to only those messages from people who really care – then they could set a high price for allowing a message to appear in their inbox.

Interesting idea. It’ll never happen, but it is interesting nonetheless.

For my Principles of Microeconomics students there is an interesting article in The New York Times about gas prices and miles driven each year. In a rough way this is like a demand curve – price on the vertical axis, and quantity (in this case miles driven) on the horizontal axis. A comment from the article:

But the latest recession has caused some big changes. High unemployment meant that fewer people were driving to work, and a slump in consumer spending meant that less freight needed to be moved around the country. As gas prices soared in 2005, the number of miles driven – including commercial and personal – began to fall, and continued to drop after 2008 even as gasoline became cheaper.

From The New York Times

This image – click on it for a larger view – shows periods of what we would expect from a demand curve – downward sloping, showing more miles driven when gas prices are lower.  However there are periods where prices change and driving miles don’t, or when prices increase and miles driven increase.  What gives?

The key is found in the title of this post – ceteris paribus – which loosely translated means “all things remaining equal.” In a typical demand curve we look at changes in price and their impact of demand. We assume that everything else about the market is held constant – remain equal. For this chart, which shows annual data from 1956 to the present, ceteris paribus is not in play. There are many things changing, including driver incomes. So some segments of this historical trend look like a standard demand curve, sloping down and to the right. In other cases, what we are really seeing is a shift in demand, driven by factors other than price.

Pretty exciting title for this post, huh?

I get little news snippets sent to me, via email, from the Wall Street Journal. Here’s one that arrived this morning.

The 10-year Treasury yield, the benchmark for U.S. consumer and corporate borrowing, rose to 4% for the first time since June.

The move extends a steady increase by Treasury yields, which move inversely to prices, lifted by a combination of stronger economic data and the barrage of debt issued by the government to meet its financing needs. Recent Treasury auctions have met with much weaker demand and Monday’s move comes ahead of more auctions this week, with the Treasury Department set to sell $82 billion of Treasury notes and bonds.

The 10-year yield is a key benchmark for mortgage rates and other consumer and corporate lending.

“So, what does this mean?” you say. I’m so glad you asked…

Someone can buy a U.S. treasury bond, for something like $1,000. Let’s say you buy one that matures in 10 years. Over the life of the bond you will receive interest on your “loan” that is set when you first purchase it. Now along the way you can decide to sell the bond to someone else.

If today’s interest rates are exactly what they were when you bought the bond, then the fair price for the bond is $1,000.  However, if interest rates have gone up, then your bond is delivering less interest than someone could get by buying a new bond at the higher rates. So, to sell the bond you need to reduce or discount the price. Someone might be willing to pay $950 for your bond, receive lower interest for the remaining years, and then get the original $1,000 back.

If today’s interest rates are lower, you’ve got an attractive bond to sell. The new owner can earn higher interest than they otherwise could and should be willing to pay a premium for the bond – perhaps something like $1,050.

The result is that the price of bonds, on this secondary market, are inversely related to the interest rate. As rates rise, the price of bonds fall, and vice versa.

And when the U.S. Government needs to sell bonds in the primary market it must offer an interest rate that will attract investors. The news item from the WSJ suggests that interest rates are rising for a couple of reasons. First, with stronger economic results, investors have been returning to the equities market (i.e. stocks), leaving the relative safety and lower yields of the bond market. So demand for U.S. bonds is lower. On the supply side the U.S. Government is accelerating its debt, and needs to sell more and more bonds to cover our deficit. So, decreased demand and increased supply means lower prices, and in this case means the starting interest rate needs to rise.

The other piece not mentioned here, but swirling around nonetheless, is growing concern about U.S. bonds and their credit worthiness. U.S. Treasury bonds have historically had the highest credit rating, reflecting, in essence, risk free investments. There have been mutterings and informal warnings from a couple of credit rating agencies, that they may downgrade U.S. treasury bonds. Were that to happen, then the Fed/Treasury would have to offer higher interest rates on those bonds – to compensate for slightly higher risk.

I’m going to post this link to a column by The New York Times‘ David Brooks – about the field of economics, so its points are not forgotten. It’s an important view of our discipline, and my colleague Ric Holt argues that he and several others have been making this point for many years now. Frankly, I have to mull it over. I’m inherently suspicious of pronouncements that say, “The King is dead. Long live the King!” They often set up the old “king” as full of faults, and welcome the new improved king. Holt et al use neoclassical economics as the label for the old king.

In any case Brooks is worth a read. Here are a couple of excerpts:

Some brilliant scholar has to write a comprehensive history of modern economics because the evolution of this field is clearly one of the most consequential things happening in the world today.

Act I in this history would be set in the era of economic scientism: the period when economists based their work on a crude vision of human nature (the perfectly rational, utility-maximizing autonomous individual) and then built elaborate models based on that creature.

Act II would occur over the past few decades, as a few brave economists tried to move beyond this stick-figure view of humanity. Herbert Simon pointed out that people aren’t perfectly rational. Gary Becker analyzed behaviors that don’t seem to be the product of narrow self-interest, like having children and behaving altruistically. Amos Tversky and Daniel Kahneman pointed out that people seem to have common biases when they try to make objective decisions.

read more…

Pizza Hut Double Deep Pizza

I love the cheese, the crust, and most of the other, assorted things that can go on a pizza. Sadly, many of those things are not good for me. This article, put out by Reuters, reports on a study measuring the impact of a tax on pizza on the number of pizza and soda calories consumed.

Over a 20-year period, a 10 percent increase in cost was linked with a 7 percent decrease in the amount of calories consumed from soda and a 12 percent decrease in calories consumed from pizza.

The team estimates that an 18 percent tax on these foods could cut daily intake by 56 calories per person, resulting in a weight loss of 5 pounds (2 kg) per person per year.

OK, budding economists. What does the first sentence sound like? If you said price elasticity, you would be right. They measured the change in demand of a product (with calories as the proxy for quantity of pizza) as a result of a change in price. Is calorie demand (at least for pizzas) price elastic or price inelastic?

Then, to add a policy bent to it, consider the idea of Pigovian taxes. If obesity is a negative externality (and it is – since obesity leads to higher health care costs and to higher insurance premiums, even among less heavy people) then one could estimate the impact of a pizza tax on consumption of those oh-so-good, but oh-so-bad for you consumer food items.