Friday, December 31, 2004

Happy New Year

Spring 05 Classes



It is New Year's Eve, a night when we celebrate the end of 2004 and the beginning of 2005. Instead of writing about resolutions I have decided to reprint a poem, which I came across while cleaning the garage today, by Dr. Heartsil Wilson that Michael T. Crowley Sr. published in his Chairman's Message column of the quarterly newsletter of Mutual Savings Bank at the end of 1994. I had the pleasure of starting my mortgage lending career at the then Mutual Savings and Loan Association in Milwaukee, Wisconsin under Mr. Michael Crowley who was President and Chairman of the Board. While I did not work directly for him, he had a practice of taking young managers to lunch periodically and sharing the wisdom he had acquired over many years in the industry. It is a tribute to his leadership that Mutual Savings and Loan was one of the few S&Ls that not only surrived but thrived during the Savings and Loan crisis in the late 1980s.

The poem below describes time as a resource that should be used wisely. As I have mentioned in other articles, time is a scarce economic resource. The last line ... in order that I shall not regret the price I have paid for it, is a good example of opportunity cost – refering to the things we chose not to do in a day in order to do the things that we did.

Have a Happy and Safe New Year's Eve and Best Wishes for a Healthy and Prosperous New Year?

A NEW DAY
by Dr. Heartsil Wilson

This the the beginning of a new
day. God has given me this day
to use as I will. I can waste it -
or use it for good. But what I do
is important, because I am
exchanging a day of my life for
it. When tomorrow comes, this
day will be gone forever leaving
in its place something I traded
for it. I want it to be a gain not
a loss, good not evil, success
and not failure, in order that I
shall not regret the price I have
paid for it.

Wednesday, December 29, 2004

Competition Motivates Blockbuster

Spring 05 Classes



A couple of weeks ago the Wall Street Journal carried an article entitled Blockbuster Backs Off Late Fees (December 15, 2004, page D1) in which reporter Joe Flint described how, beginning January 1st, Blockbuster will be dropping its late fees. About the same time I received a postcard from Blockbuster informing me that I had returned one of the videos I had rented in November late and owed them "Extended Viewing Fees" totaling $4.21.

According to the article, Blockbuster "euphemistically" refers to the late fee as an "extended viewing fee" and sets it equal to the usual rental fee. Blockbuster's marketing people may feel that an "extended rental fee" is more palatable that a "late fee", but, from the customer's point of view, it is probably worse. On my notice, in microscopic print above the total due was a notice that the "Total includes Tax". In Arizona at least, rental fees are taxable but late fees are not. So, thanks to Blockbuster's euphemistic wording, the State of Arizona and City of Marana, with their insatiable desire for money, were able to add their twenty-one cents worth of taxes to Blockbuster's late fee.

But, as the article points out, competition is coming to the rescue of delinquent viewers. New rental options that do not charge late fees are appearing on the market. Blockbuster itself offers a monthly movie pass that, in exchange for a flat fee of $24.95 per month you can rent unlimited movies (but no more than two at one time) for the month and keep them as long as you keep paying the $24.95 monthly membership fee. News of this offer was included with my late fee notice.

But there is more. Upstart Netflix offers customers the convenience of unlimited movies each month with no late fees. Customers are limited to three DVDs at a time and must return them before ordering more. Customers order the DVDs on-line and receive them by mail. Each order comes with a postage paid mailer in which to return the DVDs. This service has proved so popular that both Wal-Mart and Blockbuster have copied it and offer the same service.

Netflix was charging $20 per month until a few months ago but competition from Wal-Mart and Blockbuster have forced monthly fees down to $17.99 for Netflix, $17.49 for Blockbuster and $15.54 for Wal-Mart.

This is the free market in action. When videos first came out they could only be purchased, not rented, and they carried a high price. Rental companies then emerged and, in time, Blockbuster, taking advantage of economies of scale, drove costs, and prices, down by building a large national chain. With the advent of durable, light weight DVDs, the founders of Netflix saw an opportunity to cut costs further and expand customer service and convenience by eliminating expensive brick and mortar retail outlets. They jumped into an already crowded rental market and within about a year became a major player. The economic profits in the niche exploited by Netflix was sufficient to attract others and now competition within the niche is driving prices down further. The competition is now so great that not only has Blockbuster been forced to enter the "DVDs by mail" niche but is also cutting prices (in the form of reduced late fees) and offering unlimited rentals for a flat monthly fee through its retail outlets as well. Critics will quibble about technicalities. According to the article, Blockbuster is replacing its "extended viewing fee" with a plan that provides a one-week grace period after which the customer's credit card is automatically charged for the purchase of the video. If the customer brings the movie or game back within the next month they will get their money back minus a $1.25 restocking fee. But, while Blockbuster has not entirely limited the penalty for late returns, the trend is toward lower prices and more customer service choices. These technicalities are merely bumps in the road.

Tuesday, December 28, 2004

How Banks CREATE Money

Spring 05 Classes


Everyone understands that banks EARN money by charging interest and fees on the money they loan. To get the money they loan, banks entice people to deposit money with the bank and receive interest from the bank on the funds they deposit. A bank's earnings then become the difference between what they earn in interest on the loans they make to borrowers and what they have to pay in interest to their depositors.

Banks also CREATE money. As was explained above banks can earn money from the interest charged on loans made with the funds people deposit. In addition to loaning funds deposited, banks can also create new money and loan this out. For the purposes of this economics class we are not interested in how the banks EARN money from the loans they make. In this sense they are no different from any other business and not worth a chapter in the text. Gas stations make money by buying a gallon of gasoline from a wholesale supplier and selling it to a consumer. If a gas station had a way to buy ONE GALLON of gasoline from the wholesale supplier and transform it into TEN GALLONS of gasoline to sell to the customer that would warrant a chapter in the book.

But, unlike gas stations, banks do have the ability to literally create the product they sell almost out of thin air. By creating new money, banks have a major effect on the economy. Creating additional money means people have greater ability to spend and this increases aggregate demand and economic activity.

Banks have basically two types of accounts:

TIME DEPOSITS - which are various types of savings accounts including certificates of deposit (CDs). For our purposes the significance of these accounts is the fact that they require the depositor to leave the funds at the bank for a certain period of time. Certificates of Deposit actually specify the time period and if the depositor withdraws the funds prior to the expiration date they are charged a stiff penalty (often 10% or more). Regular savings accounts usually allow the depositor to withdraw the funds at any time but, legally (and it is stated in the fine print which no one bothers to read) the bank can require 30 or more days written notice of intent to withdraw the funds. While this 30 day notice rule is not enforced now days (but it is still enforceable should the bank have a need to) the bank does require that the depositor make a trip to the bank during normal business hours to withdraw the money. This, plus the fact that most people's reason for having a SAVINGS account is to SAVE money, means that savings depositors tend to let the money sit in the bank for long periods of time. This money can thus be safely lent out knowing that the depositor will not withdraw it before the loan is repaid (if I deposit $10,000 in a one year CD and someone walks in behind me and borrows that $10,000 for one year the bank knows that the funds are due back the same day that my CD expires so the funds go from me to the bank, then to the borrower who returns them in one year at which point I return to get my money back - the bank collects 10% [$1000] from the borrower, pays me my 3% [$300] and pockets the difference [$700] as profit).

DEMAND DEPOSITS - these are the second type of account and are also called checking accounts. A DEMAND deposit is an account in which the depositor can get their money back ON DEMAND at any time. The depositor simply walks into the bank and presents a check and the money is turned over IMMEDIATELY - the bank cannot refuse or delay the request. To make it even more convenient, the depositor can simply write a check and the person receiving the check has the right to go to that bank and DEMAND the funds in full immediately. Loaning these funds is riskier since the loan is usually made for a specified period of time while the deposit can be withdrawn at any time.
Close to 1,000 years of experience has taught us two things:

FIRST: People who deposit money into a checking account tend to pay for things by writing checks rather than by going to the bank to get their money and then making the payment - thus the depositors themselves rarely withdraw cash from their accounts.

SECOND: Merchants and others who receive the checks usually prefer to deposit the checks to their own checking accounts (which are often at the same bank) rather than present them for cash.

Given the above two facts, it is apparent that, despite the fact that the funds can legally be withdrawn at any time on demand, money deposited into demand deposits or checking accounts is actually more stable (in the sense of staying in the bank) than time deposits since people frequently do withdraw funds from savings when the time is up.

This fact allows the bank to, on the one hand, promise to pay the depositor, on demand, the contents of the account and at the same time loan the funds to another. Since I am writing checks against my account (spending the money) while at the same time someone else has borrowed the funds in my account and is spending that money the bank has in effect increased the amount of money in circulation by enabling two people (the depositor and the borrower) to spend the same funds at the same time.

But the money creation does not stop here. When you go to the bank to borrow the money that I deposited, the bank does not give you cash. Instead, the bank deposits the funds into your checking account (or opens an account for you and deposits the funds into it). The money stays in the vault while the bank's books show the funds in two peoples' accounts. Now both of us can write checks and the bank can be reasonably certain that the recipients of our checks will deposit them rather than ask for cash so the funds will never leave the vault.

Since the money deposited or credited to the borrower's checking account is no more likely to have to be paid out in cash than the money credited to the original depositor's account, that too can be safely loaned out. So now we have $10,000 cash sitting in the vault which was deposited by me and credited to my checking account. We also have $10,000 (forget about reserves for the moment) credited to borrower 1's checking account (which is the same $10,000 cash that I deposited) and the bank now re-loans the $10,000 in borrower 1's account to borrower 2. We now have three people, each able to write up to $10,000 in checks (so up to $30,000 worth of checks can be written) but only $10,000 in cash with which the bank can honor its pledge to pay on demand any and all checks presented from those three accounts. So long as people keep depositing their checks there is no problem, but if everyone decides they want cash the bank will be unable to honor them and will fail.

The customer's like this situation because checking accounts provide the convenience of cash but are safer (if my checkbook is lost or stolen I can put out the word not to accept my checks - but if my cash is lost or stolen there is no way anyone can identify my stolen bills) and less bulky as I can carry one million dollars in my checking account with ease but would need a suitcase to carry that much cash (if we used gold, as they did originally, rather than paper money the carrying problem is even greater).

Banks like the situation because they are able to keep make multiple loans (earning interest and fees on each one) from the same deposit.

From the economy's point of view the banks are creating money. Since checks are widely accepted in lieu of cash, then issuing multiple checking accounts backed by the same cash deposit, the bank is allowing that money to be spent multiple times. In the example above, there was $10,000 in actual cash but three people could spend that same cash thereby converting the $10,000 in cash to $30,000 worth of spending.

In the past banks, not governments, PRINTED paper money. Governments issued currency in the form of gold (and sometimes silver) coins. The U.S. Constitution gives the U.S. Government a monopoly on COINING money (i.e., only the Federal Government can legally mint coins to be used as money) which is a traditional right of governments. Anyone can print and issue paper money. Printing your own money is legal - COPYING someone else's money is illegal and is called forgery. If I make copies of U.S. $20 bills with Andrew Jackson's picture that is forgery and I can go to jail. If I print $20 Nugent Bucks with my picture on them that is perfectly legal (and worthless unless I can find some sucker to accept them).

Prior to checking accounts, banks would accept deposits of gold and issue receipts that could be redeemed for the gold. The receipts could be given to someone else to be redeemed - if I brought a cow from one of you I could pay for it with the receipt for my gold at the bank rather than going to the bank for the gold. When banks realized (about 600 or 700 years ago) that people left the gold in the bank and just circulated the receipts they began making loans against the gold by issuing more receipts. Eventually they simply began issuing standard bills (money they printed) which promised to pay, on demand, in gold. For every deposit of actual gold they found that they could print ten or fifteen times that amount in paper money to be loaned out. This was the start of FRACTIONAL RESERVE BANKING or the practice of backing up the money printed by banks or, now days, the checking accounts issued by the bank, with gold (or U.S. currency now days) that is worth only a fraction of the value of the paper money or checking accounts the bank issues.
Since people do occasionally ask for cash (or gold in the past), prudence (and now days the LAW) requires that banks not lend out 100% of their deposits, but maintain some in reserve to honor the few requests they get for actual cash. Today banks could probably get away with keeping about 10% as a reserve but the law requires a higher amount (currently about 18%) in order to give the system a greater margin for error.

It is the reserve requirement that prevents the banks from re-lending the funds indefinitely. When the bank takes a deposit it can only re-lend 82% of the amount (keeping the other 18% in reserve). Putting the 82% into the new borrower's checking account gives them the opportunity to lend it again but they can only lend 82% of that account (which was 82% of the original deposit). As you can see, each new round of lending gets smaller and smaller until eventually no additional loans can be made against the original deposit.

Monday, December 27, 2004

Competition and the First Amendment



One of the highlights of the recent election was the role played by the "new" media. I am referring to the role played by (mostly AM) talk radio, cable, the Web in general and blogs in particular. It is probably safe to say that these "new" media, which, to a high degree are ideologically conservative and politically pro-Republican, played a pivotal role in the Republican presidential victory as well as the Republican victories in the House and Senate.

There have been many criticisms of the "new" media – it is biased, many are not So instead of being concerned about bias and lack of professional journalistic credentials in the new media we should welcome and encourage this media as well as encouraging the mainstream media to drop their pretense of impartiality and professionalism and join the fray. Just as competition in the marketplace continually improves our material well being, this competition in the marketplace of ideas can only serve to improve our political discourse.

Sunday, December 26, 2004

Yes Virginia, There Is a Santa Claus

Spring 05 Classes


I decided to continue the Christmas season theme today by reprinting Francis P. Church's famous editorial in the New York Sun newspaper entitled Yes Virginia, There is a Santa Claus. The editorial first appeared on September 21, 1897 in response to a letter from the eight year old, Virginia O'Hanlon of New York City and was reprinted on the editorial pages of the New York Sun every year until the paper ceased publication in 1949.

While the public focus of the holiday is on shopping and retail sales statistics, it is important to remember that there is a spiritual as well as a material aspect to Christmas and without the spiritual part the holiday is reduced to just another exercise in consumption. As I pointed out in my December 6th St. Nicholas Day posting, http://nugent-economics.blogspot.com/2004/12/st-nicholas-patron-saint-of-children.html Christmas has always been a mixture of both the secular and religious and gift giving has been a part of the mix from the beginning with the Magi bringing gifts to the Christ Child.

So why is this a concern of economics? First of all, not only have theologians and philosophers, from ancient times to the present, made pronouncements about economic issues, but the science of economics had its origins in moral philosophy. The scholastics at the University of Salamanca in Spain began the theoretical groundwork for modern for modern free market economics in the fifteenth century. Adam Smith, the father of modern economics, was a professor of moral philosophy. Secondly the spiritual values that Francis P. Church lauded in the editorial with the words "Only faith, poetry, love, romance, can push aside that curtain and view and picture the supernatural beauty and glory beyond" can only be pursued by people who have advanced beyond the simple material existence stage of development and mastered the skills of specialization and division of labor. Our first primitive ancestors had to devote full time to satisfying basic material needs of obtaining food and shelter. Only after they learned to organize and begin producing a surplus of food and shelter could they afford to indulge in higher pursuits that feed the spirit.



Editorial Page, New York Sun, September 21, 1897 - We take pleasure in answering thus prominently the communication below, expressing at the same time our great gratification that its faithful author is numbered among the friends of The Sun:
Dear Editor,
I am 8 years old.
Some of my little friends say there is no Santa Claus.
Papa says, "If you see it in The Sun, it's so."
Please tell the truth, is there a Santa Claus?
Virginia O' Hanlon, 115 West Ninety-fifth Street

Virginia, your little friends are wrong. They have been affected by the skepticism of a skeptical age. They do not believe except what they see. They think that nothing can be which is not comprehensible by their little minds.

All minds, Virginia, whether they be men's or, children's, are little. In this great universe of ours, man is a mere insect, an ant, in his intellect as compared with the boundless world about him, as measured by the intelligence capable of grasping the whole truth and knowledge.

Yes, Virginia, there is a Santa Claus.

He exists as certainly as love and generosity and devotion exist, and you know that they abound and give to your life its highest beauty and joy. Alas how dreary would be the world if there were no Santa Claus!

It would be as dreary as if, there were no Virginias. There would be no childlike faith then, no poetry, no romance to make tolerable this existence.
We should have no enjoyment, except in sense and sight. The external light with which childhood fills the world would be extinguished.

Not believe in Santa Claus!

You might as well not believe in fairies. You might get your papa to hire men to watch in all the chimneys on Christmas eve to catch Santa Claus, but even if you did not see Santa Claus coming down, what would that prove? Nobody sees Santa Claus, but that is no sign that there is no Santa Claus.

The most real things in the world are those that neither children nor men can see. Did you ever see fairies dancing on the lawn? Of course not, but that's no proof that they are not there. Nobody can conceive of, or imagine, all the wonders there are unseen and unseeable in the world.

You tear apart the baby's rattle and see what makes the noise inside, but there is a veil covering the unseen world which not the strongest men, nor even the united strength of all the strongest men that ever lived could tear apart. Only faith, poetry, love, romance, can push aside that curtain and view and picture the supernatural beauty and glory beyond. Is it all real? Ah, Virginia, in all this world there is nothing else real and abiding.

No Santa Claus! Thank God he lives and lives forever. A thousand years from now, Virginia, nay 10 times 10,000 years from now, he will continue to make glad the heart of childhood.

Friday, December 24, 2004

The Night I Worked for Santa Claus




My Spring 05 Classes


Since the days of the Great Depression, the Christmas season has been watched closely by economists, policy makers and securities analyists. This is a major retail event and retail sales at this time a year not only have a major effect on the economic health of retailers but also on manufacturers as the volume of retail sales has a direct effect on inventories.

Employment numbers also tend to increase as retailers and others take on additional workers to cover the longer hours and anticipated increase in consumer traffic.

In my student days I too had some part time jobs with department stores during the Christmas holiday season. But my really unique holiday job occurred on the evening of December 23rd about twelve years ago. At that time another fellow and I owned a small computer training and consulting firm and we worked out of some space in a photography studio owned by my partner's son-in-law.

Jim, the son-in-law, had a good business and that year he got the Santa Claus concession at the Foothills Mall. But he had some gaps in the schedule for his Santas so he asked his father-in-law and me if we would be interested in filling them when they arose. We accepted but, in the end he only had about three gaps, so my partner took two and I took one.

Mine was for the evening shift from six to ten. They had a small dressing room in one of the empty stores in the mall where I donned the pillows, red pants, coat and hat along with my long white beard and black boots. Fortunately, the clothing was light so it was not uncomfortable. I then took my position in the big chair in "Santa's Workshop" and waited for the children to come.

The Foothills Mall was not as busy in those days but we had a small, steady flow of children coming to see me. While not very good for the businesses, the light shopping crowd meant that the children did not have to wait in line to see me and did not have to be rushed off right after their pictures were taken. In the beginning were the younger children with their parents. The very young ones came forward hesitantly and barely spoke while the older ones strode forward boldly and provided me with very specific instructions as to what they wanted for Christmas. All were polite and well behaved. Some of the more organized ones brought me lists and I dutifully put these in my pocket. In my most reassuring manner I would assure each child that, if they went to bed early, I would stop by their homes the next evening with presents for them. However, and as a parent myself I certainly wanted store Santas to say this to my children, I cautioned that I had children all over the world to visit and I couldn't guarantee that I would have the specific gift that each one requested. But I would do my best and every child could look forward to a nice surprise under their Christmas tree. This way, if the child asked for something beyond the parent's budget or they secretly confided the gift in me, the parent's would not be on the spot when that hoped for gift was not under the tree.

A fringe benefit of the job was Christmas cookies that a few of the children brought for me. Another was the young ladies who stopped by later in the evening. Small groups of teenage girls doing last minute shopping would glance at our display and giggle as they passed. As the evening wore on and the younger children and their parents left, individual groups of these young ladies would linger a few moments and finally one or two from the group would get up the courage to come and have their picture taken with Santa. They were beyond the age of believing in Santa Claus but I am sure they had a great time the next few days passing around the picture of themselves sitting on Santa's lap.

My pay for the evening was $25 along with cookies and the satisfaction of having made a number of children, young and old, happy. Unlike the movies, all of the children that visited with me that evening were well behaved and believed in Santa Claus and the spirit of the season.

Merry Christmas!

Thursday, December 23, 2004

Conservation run Amok

Spring 05 Classes



I received a Christmas card last night from some old friends who live in northern Wisconsin and in the enclosed annual letter they mentioned that Paul got his deer early this year – unfortunately he bagged it with his car. It cost over $700 to repair the damage to the car and this is the third time my friends have had to pay for damages to this car resulting from collisions with deer.

In a way my friend was lucky – according to the University of Wisconsin's Deercrash.com website, 367 people were killed in animal-vehicle crashes nationally in 2003. In a recent Wall Street Journal article (de gustibus: Bambi Buys The Farm, December 10, 2004, page W17) reporter Mary Anastasia O'Grady reports that, according to a 1995 University of North Carolina study the annual cost of property damage resulting from animal-vehicle accidents was $1.2 billion and most of the "animals" involved in these crashes were deer.

Deer, once thought to be vanishing, are now thriving to the point where they are becoming a menace. The eastern half of the U.S. is overrun with them and the population keeps growing. A century ago conservationists, fearing that deer would become extinct, turned to the government (state governments in this case) for help. Government policies may or may not have saved the deer from extinction. But these policies have definitely helped to increase the population to the point where it is now out of control. Yet, like all government policies, once in place it is very difficult to turn them around. The bureaucratic mindset can only concentrate on one thing at a time – if bureaucrats designed cars they would solve the problem of getting the car moving by installing a gas pedal. But it would probably take years and millions of crashes before they realized that people also need to stop cars and, hence, require a brake pedal as well. So the current bureaucratic solution to the deer problem is to continue to bow to the hunting and "Bambi lovers" lobbies by limiting the hunting of deer and keeping it illegal to raise deer commercially for meat. While, at the same time coping with the accident problem by funding research studies (Deercrash.com is a service of the publicly funded University of Wisconsin) and running safety education programs – all of which result in the spending of more money on top of the $1.2 billion being spent on property losses caused by deer.

Proponents of the free market frequently point out that the reason rhinoceros are an endangered species and cows are not is that cows are property and belong to identifiable individuals while rhinoceros are owned by all and looked after by none. Get the government out of the rhinoceros protection business and let people own them and rhinoceros will no longer be endangered according to free marketers.

However, the deer problem one of too many not too few, so is there a role here for the free market? It just so happens that the free market can help. In the same de gustibus: Bambi Buys The Farm article, O'Grady reported on a conference sponsored by the Bozeman, Montana based Property and Environment Research Center and described how New Zealand used the market to solve their deer problem.

Former Cabinet Minister Maurice McTigue spoke at the conference and told how New Zealand legalized deer farming and repealed the laws outlawing the sale of deer meat. Deer now had value and could be owned as property. Entrepreneurs quickly began rounding up the deer, put them on farms and began selling the meat. Some deer still exist in the wild but they are no longer a problem and the rest of the deer population has been domesticated on farms with the population reduced to a manageable, and economically viable size.

In addition to solving the deer population problem, a new industry, the raising, processing and selling of venison, was created. And, thanks to laws in the United States (state laws), Canada and elsewhere, New Zealand has become the major exporter of venison. Unlike tariffs, which are designed to protect domestic industries from foreign competition, the conservation laws in other countries act as a reverse tariff, protecting the foreign (in the case New Zealand) producers from competition from their own citizens. It is illegal to harvest venison domestically for commercial purposes but it is legal to sell venison harvested abroad.

Given our huge deer population and the costs of transporting venison from New Zealand, American producers of venison would probably have a comparative, if not an absolute, advantage over New Zealand producers in the North American market. But our politicians, bowing to special interests, insist on maintaining their present policy of protecting deer from commercial interests on the one hand while, at the same time spending billions repairing property damage and trying to educate people on how to cope with the out of control deer population.

Meanwhile, New Zealand has solved the problem and given their economy a boost in the process.

Tuesday, December 21, 2004

Trade and Defense

One of the arguments given by students this semester in answers to questions dealing with whether or not there should be restrictions on trade involved the national defense argument.

While generally acknowledging the logic of free trade protection of jobs and national defense were often put forward as reasons to give up the benefits of free trade.

However, this is not a very good reason as, historically, nations have imported the weapons and other material needed to wage war. During the American Revolution the Continental Congress sent Benjamin Franklin, Thomas Jefferson and others to Europe to negotiate loans from foreign banks and governments and then used the proceeds to purchase weapons to fight the British. Franklin obtained from France the ship, renamed the Bonhomme Richard, in which John Paul Jones took on and defeated the British ship Serapis, in a battle that is celebrated by the U.S. Navy to this day. The U.S. loaned England and France money to purchase weapons, food and other material to fight the Germans in World War I and the U.S. eventually entered the war partly as a result of German submarines trying to stop the U.S. trade with England by sinking our ships. In World War II it was trade, including large amounts of weapons, with the U.S. that kept England from being overrun by Germany. We also kept the Soviet Union supplied with weapons, food and other supplies that enabled them to continue fighting the Germans during World War II.

In recent years armaments have been a major U.S. export (also a major export for other countries like England, France, Russia, Brazil, Israel, etc.). The weapons used by Saddam Hussein against our recent invasion of Iraq were all obtained by trade with other nations and part of the current ill feelings between the U.S. and France and Russia is our belief that they opposed us in the U.N. Security Council is because they stood to lose Iraq as a customer for their weapons if we overthrew Hussein.

One of the reasons given for the Japanese attack on Pearl Harbor was our government's ban on the selling of scrap metal to Japan. But ironically, while Japan went to war against us because we cut off a resource needed for their war effort, the lack of scrap metal from the U.S. is never given as a reason for their losing the war. Similarly, the Japanese cut off our access to rubber (needed for tires for planes and military vehicles) and silk (needed for parachutes) two goods we could not produce but needed for our military. To make up for the loss of these natural products we invented synthetic rubber and nylon a synthetic substitute for silk.

So, while there is a certain surface logic to the idea of being self sufficient in defense production, the reality is that most nations obtain large amounts of war material during war time via foreign trade rather than via domestic production.

Monday, December 20, 2004

End of Semester Observations

I had to take the past week off from writing this blog to concentrate on grading papers and posting grades.

While my systems for managing the workload ran very well this semester, they were strained by the, not unexpected, end of semester rush. Three of my classes are self-paced courses and I have always had a policy of letting the students set their own schedules for doing the work. I do provide them with a suggested schedule for turning in work in a timely manner and cite examples of past students who have attempted to do everything in the last week or two and end up with a D or an F for a final grade. But, every semester there are a few of what I call "sleeper" students who wait until the last minute and hand everything in at once.

I had a fair number of sleepers this semester but a number of them "woke-up" two to three weeks before the end of the semester and seemed to put in considerable time and effort to produce quality work. Most of these ended up with an 'A'. Although, one did miscalculate and did not allow time for the mid-term (the mid-term and final exams had to be taken at the college testing center, but could be taken at any time). This student got near perfect scores on all of the assignments and a high score on the final exam but the loss of the 150 point mid-term resulted in a 'B' rather than an 'A' for the course. Of course, there were the usual ones who did not wake up until the final weekend and the 'D' or 'F' they received reflected the quality of their output. Finally, some have yet to wake up and they account for a large portion of the 'F' grades I gave out this semester.

I had two couples enrolled in the same course in two of my classes. I didn't hear anything from them until about Thanksgiving when they began submitting some assignments. All four of them handed in the majority of their work during the last week and it was included in the large pile of work I was handed when I came for my office hours on Monday night. If nothing else, these two couples (one couple in the macro class and the other in the micro class) appear to have grasped the concepts of division of labor and use of capital. While reading an assignment I would suddenly have a sense of deja vu – I had read this before, about five minutes before. Sure enough, digging into the pile of corrected assignments there was the same assignment from that person's partner and the only difference was the student's name and formatting of the text. The answers were the same word for word – one partner wrote and printed it and the other changed the name at the top and changed the line spacing and re-printed it. It turned out that one couple did this about half the time and the other about a quarter of the time in the pile that I had received on Monday evening. Submitting someone else's work (even when that "someone else" is your spouse or significant other) is what has traditionally been called "cheating" (see Student Code of Conduct), but, rather than giving zeros on those assignments I decided to give them a break. All of their other work and closed book tests were good quality so I decided this time to let it go. But, I couldn't let such a stupid mistake pass without comment – after all, if you are going to cheat at least make an attempt to cover your tracks by handing the assignments in at different times. So, when I came to the second copy of the assignment rather than grading it and making comments, I just made a note in red at the top telling the student to see his/her partner's paper for the grade and comments.

This semester was the worst in terms of volume of last minute assignments and this was magnified by the fact that, with the new on-line grading, my window for grading papers and recording the grades is effectively narrowed to about four days. Worse, in addition to having to work at my regular, non-teaching, job during the day, my time is further limited by the fact that I only have a few hours after work to access the computer to post the grades since the Banner system is taken down every evening from 10 p.m. Until 7 a.m. So, starting next semester, the deadline for turning in work will be moved back to at least a week before the end of the semester.

Friday, December 10, 2004

Wal-Mart, China's Fifth Largest Trading Partner

In my first lecture for my Economics 200 class at Mountain View High School this past fall, I tried to give the students an idea of the immense size of the U.S. economy by listing the following statistics:

2002 Gross Domestic Product (GDP) of the U.S. was ten trillion, four hundred billion dollars ($10,400,000,000,000).

The total Gross Domestic Product for the world for 2002 was $49 trillion dollars – meaning that the U.S. produces over one-fifth of the world's output.

If we divide the World GDP of $49 trillion by its population which is 6 billion, 3.4 million people we get a per person (or per capita) figure of $7,775 (the amount each person on earth would receive if the World GDP was evenly divided).

If we divide the $10 trillion U.S. GDP by its population of 300 million people, we get a per person GDP of just under $36 thousand.


You can see that the U.S. has a huge economy and is extremely wealthy in terms of goods and services produced and available here. But additional comparisons get even more interesting.

The second largest GDP is China with $5 trillion 700 billion ($5,700,000,000,000) but with its population of just under 1 billion 300 million people we get per capita GDP of only $4,429. China has a very large population so it can produce a lot. But, unlike the U.S., China lacks capital so its output per person is a fraction of that of the U.S.

If it were an independent nation rather than a part of the United States, California with its total output of $1 trillion, 352 billion would be the ninth largest economy in the world. Dividing its output by its population of 34.5 million people we get a per person GDP for California of $39,187 making Californians richer on average than the rest of the people in the U.S. What is more interesting is the fact that if California were to leave the U.S. and become an independent nation the U.S. would remain the largest economy in the world even after California's GDP was subtracted.


In my lecture I then took the analysis a step further by pointing out that Wal-Mart, whose annual revenues of almost $220 billion make it not only the world's largest corporation but also would rank it as the 36th largest economy in the world (with annual revenue being the corporate equivalent of a nation's GDP). Again, if Wal-Mart were to become an independent nation along with California and its revenue removed from the U.S., the remaining U.S. GDP would still be the largest in the world.

Now, in its November 17th issue, the Wall Street Journal described the impact of Wal-Mart's purchases from China on world financial markets. In an article entitled How Wal-Mart Treads Heavily in Foreign-Exchange Forest (by Robert Flint, page C3) Wal-Mart comes across as a major trading power whose purchases are greater than the imports of most nations.

According to the article, in the fiscal year ending January 31, 2004 Wal-Mart purchased $15 Billion in goods from China. This was 10% of the total U.S. imports from China. The volume of Wal-Mart purchases in China make it the fifth largest importer of Chinese goods in the world. In other words, Wal-Mart is China's fifth largest trading partner placing it ahead of nations like Great Britain and Russia. And while Wal-Mart imports from China are more than those of most other nations, its imports are only 10% of the total U.S. imports from China.

Thursday, December 09, 2004

The Role of Rent

My Spring 05 Classes


It is that time of year again, the end of the semester, and students' work is flooding in just as it did when I was a student turning work in just before the deadline. As in past years, this is when I see what points I should be emphasizing next semester (it is too late to push these points this semester since it is almost over).

One of the concepts I have noticed students having trouble with is the role of rent in the housing market. On one of the take home tests is a question about what is the purpose of rent and one of the choices is "to transfer wealth from renters to landlords".

Since students are more than likely renters, this may be a logical conclusion. However, the correct answer is "to allocate scarce housing resources". The frequency of this answer leads me to conclude that it may be the term "rent" rather than the concept that is the problem. The same students who miss this question have no problem correctly identifying prices as the mechanism by which scarce resources are allocated or identifying intrest as a mechanism for allocating loanable funds.

Prices, whether they be called interest, rent or whatever serve to ration scarce goods. Housing is a scarce good. At any given time there is a fixed amount of living space available and it is divided up according to who can afford to pay the most. If there is a lot of space relative to the demand rents will be low. If there is very little relative to demand rents will be high. When rents are high, landlords will be encouraged to increase the quantity of housing/living space in order to make more money. This can be done by building additional housing, buying mobile homes in other areas and moving them here, renting out extra rooms in their own home, etc. In other words, rising rents encourage people to create and make available more living space for people.

So, yes paying rent involves the transfer of money from the renter to the landlord but this is no different than transfering money from the shopper to the grocer when shopping for food or driver to car dealer when buying a car, etc. Rent is simply the price of housing.

Wednesday, December 08, 2004

Research Funding

My Spring 05 Classes


One question that I have periodically asked over the years on tests is "what is the source of the largest shareof research and development funds in the U.S.?" When the question is multiple choice the choices usually include, universities, nonprofit foundations, the federal government, industry, colleges, etc.

At least ninety percent of the time the students' answer is the federal government rather than private industry. But the fact is, private industry is the source of the majority of the research and development in the U.S. Further, most of the funding for the research comes from private industry as well.

The reason why U.S. industry remains competative in the global economy is due in large part to their emphasis on research to develop new pharmaceutical drugs, new electronic devices, computer chips that are smaller and faster, cars that use less fuel per mile, etc. While most of the research done by U.S. industry is appliled research (objective of research is to solve a particular problem rather than seeking knowledge for its own sake), rather than basic research (i.e., seeking knowledge for its own sake), industry still spends more of its own money on reasearch than does the federal government, universities or nonprofit foundations.

Sunday, December 05, 2004

Loans vs Equity

There has been some confusion among some of the students in my classes between loans and equity.

Loans are exactly that, a loan of money to a company. A loan consists of a promissory note which states the amount of the loan, the interest rate, the term of the loan and any other conditions. It is a contract in which the borrower promises to repay the loan with interest on the time table stipulated in the note. It is a contract between the borrower and the lender and can be legally enforced. A loan may be secured or unsecured. A secured loan is one in which the borrower pledges an asset as a guaranty that the loan will be repaid. If the borrower fails to repay the loan the lender has the right to sell the asset to recover the amount due. Because there is property with a value equal to or greater than the amount lent, this type of loan carries a lower rate of interest than an unsecured loan. An unsecured loan is just that, a loan that is backed up by nothing more than the borrower's promise to repay it.

Lenders, those loaning the money, can be institutional lenders such as banks, finance companies, etc. or individuals with money to lend. Bonds are a means of borrowing, used by large corporations and governments, to raise a very large sum of money from a large pool of lenders. The lenders in this case can be other businesses, banks and/or individuals. Bonds can be secured by assets or be unsecured.

Equity investments which include shares of stock in the case of a corporation or a property interest in the assets of a partnership. These are not a loan of money but the actual purchase of a portion of the company.

In the case of a loan, the lender makes money available on a temporary basis to the company with the expectation of getting the money back with interest. If the company (or individual in the case of individual loans to consumers to buy a car, house, etc.) goes bankrupt the assets of the company or individual are sold and the proceeds divided up among the creditors with those having secured loans getting paid first, followed by unsecured and other creditors. If anything is left AFTER all creditors have been paid it goes to the owners. In the case of stockholders or partners in a business they get whatever, if anything, is left from the sale of assets after all creditors have been paid.

However, if the company is successful it is the owners of the business, stockholders or partners, who benefit from the increased value. The lenders only get their money back plus interest.

Lenders share in neither the profits nor the liability of a business. A lender is not held liable for legal judgments (i.e., money owed from being sued) or for the payment of other creditors. Lenders only can only lose up to the amount they loaned plus interest. Partners in a partnership are liable for everything the business owes regardless of how much or how little they have invested. In the case of corporations, the limited liability feature of the corporate form of organization prevents the owners from losing more than they have invested. In this way they are like lenders. But there are a couple of differences, the first being that the lender is legally entitled to receive the interest due on the money they loan but stockholders only receive dividends if there are sufficient profits. The other difference is that if the company is successful the stockholders can see their investment increase and can keep the increase while lenders are entitled to only the amount they have lent plus interest.

Friday, December 03, 2004

Good News about Outsourcing

Much concern has been expressed in the past couple of years about the disappearance of American IT jobs due to outsourcing. Outsourcing occurs when American companies, in an effort to reduce costs, contract with companies overseas to do work they had previously been employing Americans to do in the U.S.

As usual, journalists, politicians and even some economists took a Chicken Little "the sky is falling" approach to this normal economic adjustment to changing market conditions. Committed statists, this group always focuses on the problems associated with change rather than the emerging opportunities.

One area of the IT industry seriously impacted by outsourcing is call centers. Advances in telecommunication and computer technology created the conditions that made call centers economically feasible and the industry developed and grew rapidly creating numerous new jobs, including many in Tucson, that had previously not existed. But the growing American economy keeps increasing its demand for labor and this increasing demand results in rising wages which increase production costs. This forces us to keep directing labor toward industries with higher productivity and forces industry to automate or export jobs that are labor intensive and expensive. Call centers are labor intensive and the same technology that led to their creation in the U.S. made it possible to transfer call center work to developing countries with large supplies of labor and the resulting lower wages. Call centers in India and the Philippines, with their lower wages, can perform the same call center services at a cost per transaction that is 25% - 35% lower than in the U.S.

But, contrary to the fears of the Chicken Littles, the economy did not freeze into a situation where Americans were permanently unemployed and Indians and Filipinos basked in the jobs the Americans "lost" to them. Growth of the call center industry in places like India and the Philippines caused demand for labor in those areas to increase and as the demand increased so did wages. Soon companies and workers in those areas found themselves facing competition from other developing countries, like Russia, that had large numbers of workers and low wages.

But, in addition to competition from developing nations further down the economic ladder, call centers in India and the Philippines face stiff competition from a new and very low cost competitor – the United States!

A short, three paragraph piece on page 14 of the November 22nd issue of the technology industry magazine Information Week, reveals that high tech companies in the U.S. have been perfecting speech-enabled, self-service technology that can provide call center services at a per transaction cost that is 15% - 25% LOWER than Indian call centers. Sure, the numerous telephone jobs at American call centers are gone forever. But other positions remain and the companies developing the speech-enabled technology need people to design, produce, sell, transport, program, maintain and service the equipment and these will be good paying jobs. So, while the market is busy destroying jobs on the one hand it is creating even more jobs on the other.

Thursday, December 02, 2004

Absolute vs Comparative Advantage

In discussing international trade, economists use the terms absolute and comparative advantage to describe how to determine trading relationships that are most beneficial to each partner.

Absolute advantage means that one nation has an undisputed advantage, in terms costs, over the other in the production of a good. If, because of its climate, Israel can grow oranges at a lower cost (i.e., use fewer resources) than Iceland and Iceland can harvest cod fish at a lower cost than Israel, then Israel should export oranges to Iceland and Iceland export cod fish to Israel. This is an easy concept to grasp and students usually do not have a problem understanding it.

The problem comes in when you have a country that has an absolute advantage in both products. The U.S., due to its geography, can produce both oranges and cod fish at a lower cost than Canada. This does not mean that the U.S. Should produce and export both. Rather, Canada should produce and export the product in which it has the lowest opportunity cost and the U.S. should specialize in producing the other one. In this way there will be more of both products for each country.

A very simple example of this is the case of a husband and wife who have eight hours available on Saturday to relax and enjoy themselves at their weekend get away cottage on the lake. They would like to spend as much of the day as possible cruising on the lake in their boat. However, it has been a few weeks since thay had time to visit the cottage and both the inside and the yard need cleaning. Based upon past experience, they know that the wife can do either job in two hours. But it takes the husband four hours to clean the cottage and three hours to do the yard work.

If the wife, who has an absolute advantage in both tasks, does both jobs it will take her a total of four hours (two to clean the house and two to do the yard work) to complete the tasks. This will leave the couple with four hours to cruise on the lake. However, if the husband does the yard work which has a lower opportunity cost than the housework for him (three hours for yard work vs four hours for housework) both jobs will be done in three hours leaving the couple with five hours to spend in their boat.

This is the concept of comparative advantage.

Sunday, November 28, 2004

Why Do the Prices of a Bond Fluctuate between Issue and Maturity?

A student recently asked why the prices of previously issued bonds fluctuate even though they have a face value of $1,000 which the current owner receives when the bond matures.


Bonds are debt insturments issued by corporations and government entities. Basically, the business or government (the Federal, state, local or an agency like FNMA or entity like Pima College) has a need for a large sum of money and raises that sum by selling bonds. Bonds are usually issued in $1,000 units – that is, each individual bond has a value of $1,000. Most bonds have a fixed interest rate and are usually redeemable in 25 - 30 years (i.e., the buyer does not get their $1,000 back for 25 - 30 years). Interest is paid quarterly, semi-annually or annually for the life of the bond by the issuing authority and the principal (the $1,000 the buyer paid for the bond) is re-paid at maturity (25 - 30 years later). The interest rate is fixed and that is the rate the issuer pays to the owner of the bond during the life of the bond.

If the buyer of the bond wants her money back before the bond matures in 30 years she can sell it to another person. For instance, I may buy a bond paying 10% interest with a 30 year maturity. Five years later I need money to help pay my child's college tuition. So I sell the bond to you. While I owned the bond I received the interest payments. Now that you own it they are sent to you. If you hold the bond to maturity you will receive the $1,000 face value (i.e., what it was originally sold for) that I originally paid. But you can also sell it to someone else if you do not want to wait until maturity for your money.

While the face value of the bond does not change, the amount subsequent buyers are willing to pay does change. Interest rates are the main thing that causes bond prices to change when they are traded before maturity (there are some other factors influencing the price as well but we can ignore them for now). Assume that rates were 5% when I brought the bond and that is the rate the bond pays. Pima College or IBM or whoever issued the bond is obligated to pay $50 per year (05 * 1,000) to the owner of the bond. Now suppose five years have gone by and I want to sell this bond paying 5%, but interest rates are now 10%. You are not going to pay me $1,000 for this bond paying $50 per year when you can buy a new bond being issued by some other company or government paying the current rate of 10% or $100 per year. To get you to buy my 5% bond I have to lower the price to the point where the $50 per year being paid is equal to 10% of what you paid me for it. Therefore, I will sell it to you for $500 so that the $50 annual interest paid on the bond is equal to 10% of the amount you paid for the bond.

Similarly if I had purchased a bond that paid 10% interest and rates dropped to 5% then numerous people would want to buy it from me for $1,000 so they could get 10% rather than the current 5% on their $1,000 investment. These people would compete for the bond and bid its price up until it reached $2,000 (at which point the $100 per year interest being paid would be a 5% return on their $2,000 investment).

This is why bond prices fluctuate as interest rates fluctuate when they are resold or traded before maturity.

Friday, November 26, 2004

Tax Cut Article - Part 5 of 5

We now come to the last part of the question and that refers to the quality of the jobs being created.

Like the Reagan tax cut in the 1980s, opponents of the Bush tax cut are reluctantly conceding that the tax cut is creating jobs, but they criticize it for both not creating enough jobs and for creating mostly lower wage jobs.

The simple response to this is that, since there are more entry level and other lower end jobs than there are higher end jobs, it is logical that there would be more lower end jobs created. Remember the story about Ronald Reagan when he was an actor and limited himself to making five movies per year because the high marginal tax rates would tax away most of the earnings from the sixth. It was pointed out that, in addition to Reagan voluntarily making himself unavailable for a sixth movie, all of the lower paid supporting cast as well as support crews also lost out on the chance to be employed on the sixth movie.

New jobs are being created at both ends of the spectrum and in the middle but, since higher end positions usually require many more lower paid positions to support them, more lower end jobs will be created. Also, many of the new higher end jobs are taken by people who are already employed and see a chance to move up or people, like Ronald Reagan, who are not unemployed, in the sense that they have voluntarily limited the amount of work they do, and are now incrasing their employment activities in response to the new tax environment.

Another factor, usually not considered by the media and oposition politicians, is the fact that, due to increasing efficiency and output per worker, money wages are flat or increasing slowly while prices are falling. The falling prices mean that real wages (the amount that the money wages will buy) are increasing. This means that, despite the fact that money wages are not rising, workers are able to afford more with the money wages. This is the same as a raise in money wages when prices are constant. This is called secular deflation and occurs when the aggregate damand curve remains relatively constant while the Long Run Aggregate Supply Curve keeps shifting to the right as output keeps increasing.

The job quality issue, like the other aspects of the tax cut, can be looked at in more than one way depending upon the viewer's perspective. What is happening is that our economy is moving away from central management from Washington and toward a more free market model. The majority of the people benefit from this in the form of more products and lower prices and this is good. But there are some losers and they are the ones who were fortunate enough to get jobs in protected areas (such as unionized manufacturing) where the government protected their high wages from competition. But the cost of that system of protecting the higher than average wages of certain groups of workers came in the form of everyone having to pay higher prices.

Wednesday, November 24, 2004

Tax Cut Article - Part 4 of 5

Has the Bush Tax Cut Created Jobs?


Today we will deal with the next part of the question which is how effective has the tax cut been in creating jobs?

As I indicated in yesterday's article, there is a lag between the time the tax cut is enacted and the time households respond to the new environment. Since the tax cut was across the board in that it affected all income brackets, there was some Keynesian style stimulus on the demand side as many of the recipients began spending this money. As people began spending the additional money from the tax cut there was an increase in demand and business responded by drawing down inventories and hiring more people to increase output to replenish the inventories.

The most recent figures from the Bureau of Labor Statistics' payroll survey show an increase of 2.4 million jobs from August 2003 through October 2004. The Department of Commerce's household survey shows an increase of 2.5 million jobs for the same period. The difference is that the BLS figures are based upon a survey sent to existing businesses while the Commerce figures are based upon a survey of households which include people who have started their own business or work for very small new businesses both of which are overlooked in the BLS survey.

In addition to the 2.4 or 2.5 million new jobs created, the national unemployment figure for October 2004 was 5.5% which is down from the peak rate of 6.3% in June 2003. It is also lower than the average rate in the 1970s, 1980s and 1990s. Another encouraging sign in the 5.5% rate for October was that it increased by a fraction of a percent over the September figure. This is encouraging in the sense that one sign of an improving employment picture is an increase in the rate of unemployment. If you review the discussion of unemployment in your text you will notice that the official definition of unemployment is people who are both out of work and actively looking for work. If laid off workers get discouraged and stop looking for work, as happens in recessions, they are no longer included in the official unemployment statistics. When the job market improves, as it is doing now, these people begin looking for work again and they are reclassified as unemployed and are again included in the unemployment statistics.

So, with all this good news why do we hear so much about the tax cut not working? Obviously, during the recent election Senator Kerry and the other Democrats opposing President Bush and the Republicans could not praise the President for his good job and, at the same time, try to convince people to vote him out. Much of the mainstream media and others oppose President Bush and the policies that he is pursuing so they will naturally be critical of his policies. This is normal political debate.

But there are also some legitimate grounds for criticizing the effectiveness of the tax cut and of President Bush's economic policies in general. Like any policy, President Bush's economic policies in general and the tax cut in particular, are not perfect. If they were we would have zero unemloyment, stable prices and overall prosparity. Obviously this would be impossible to achieve, but to the extent we fall short of this ideal there is room for opponents to criticize the Presient's performance and put forth alternative policies that they feel will do better. In the recent election the voters could see the results to date of the President's policies and had to estimate how accurate the claims of the effectiveness of his opponents' proposed policies were. To the extent that people based their votes on economic considerations, we can say that a majority of the electorate felt more confident in staying with the existing policy than taking a chance on the alternative policies.

A second reason for questioning the effectiveness of the President's policies is the fact that the U.S. Is a large and diverse nation and the increase in jobs is not evenly distriubted throughout the nation. The Administration's own web page contains data that can be read in either a positive or negative light. According to the Administration, Job creation was up in 47 of the 50 states in the last year, and the unemployment rate was down in all regions and in 46 of the 50 states. This is good news if you are employed and living in one of the 47 states where job creation was up or one of the 46 states where unemployment was down. But what about unemployed people in the three or four states where jobs were not being created rapidly or unemployment was not going down? They obviously have a different perspective.

So, short of the policy either working spectaularly or failing massively, the relative effectiveness of the policy will depend upon each individual's point of view and opinion of the current and alternative policies. My job as your instructor is to teach you the principles of economics and provide you with a clear understanding of the various theories behind the competing policy positions. The decision as to whether a particular policy is better or more effective than competing policies is up to you but, hopefully, as a result of this class your opinion will be backed up with an understanding of the principles and theories involved and not rely upon political hype alone.

Tuesday, November 23, 2004

Tax Cut Article - Part 3 of 5

Where the Bush Tax Cuts Effective?


Part of the student's original question was "...would you say President Bush's tax cuts were ineffective because of the deficits they created?"

The idea behind the supply side type tax cut that President Bush signed into law is that marginal tax rates are too high and these high rates discourage discourage people from increasing their incomes by working more. The idea is to reduce the rates to encourage more work which means more income is earned and that increases the amount of income available to tax. In theory the increase in income due to the tax cut will be proportionately larger than the percentage reduction in tax rates so the new, smaller tax rates times the new higher incomes will produce more tax revenue. As an example, ten percent of $100 is $10 while 8% of $150 is $12. In this example the smaller rate against the larger base resulted in a larger amount collected ($12 rather than $10).

There is a lag between the passage of the tax cut and the time the people adjust their work hours. Once a tax cut law is passed people see that they can keep more of the extra money that they earn and are then more receptive to additional work. But actually increasing work hours takes time. When companies have the need for overtime work they will find employees more willing to volunteer for such work. Also, some people will begin looking for part-time jobs to supplement their incomes, stay at home spouses will find it advantageous to return to work, and high income professionals will find it profitable to increase their service offerings.

Ronald Reagan used to tell the story about when he was a movie actor he found that he could live very well doing five movies per year. But if he did a sixth movie it pushed him into a higher tax bracket and most of the additional income from the sixth movie went to taxes. So he limited himself to five movies per year. It was not just Reagan's income from the unmade sixth movie that was lost to the IRS but also the incomes of all the other minor actors and support people – people whose incomes were much less than that of the star, Reagan, and who wern't faced with losing most of the extra income to the IRS but they, and the IRS, lost out on that extra income because the sixth movie was not made. Multiply this by all the high paid actors, lawyers, doctors, etc. who deliberately limit both their hours and the hours of their staffs and you can see that large amounts of income are not being made and thus, not available to be taxed.

Initially taxes are cut and the tax base, or total income being generated by taxpayers, remains the same so tax revenue falls. To avoid a deficit, the government should make a corresponding reduction in spending but this never happens. Remember, this was the reason the Republicans originally opposed the Kennedy Johnson tax cut was fear of the deficit. But, once the tax cuts take effect and people have time to adjust, incomes increase and this results in a larger tax base which generates the revenue to remove the deficit.

That is the theory. There is a caveat and that is that the politicians cannot be allowed to increase spending to match the increase in revenues. Government's are like my children, they can't resist the urge to spend all the money at their disposal. In the case of my children the cost of lunch in school is three dollars, but if I only have five dollar bills when I drop them off at school they manage to spend the entire five rather than bringing home the change.

The Kennedy Johnson tax cut increased revenues but, in addition to the tax cut which caused a short term deficit, President Johnson also enacted the very expensive Great Society program AND attempted at the same time to finance both the Vietnam War and the Cold War. This was too much and massive inflation followed.

Ronald Reagan's tax cut resulted in a short term deficit but he fought hard to keep spending in line and was aided by this with the Gramm-Rudman-Hollings law which required Congress to find money to pay for new programs before they could enact the programs. The result of the Reagan tax cut was over a decade of economic growth, low inflation and a budget surplus (which has since been spent by his successors).

There is reason for concern about the deficit with President Bush. Unlike Reagan, whoes philosophy was "The government is the problem" and sought to reduce government spending, President Bush's compasionate conservatism tends to see government spending as a problem only to the extent that it is not being managed responsibly. President Bush does not seem to be philosophically opposed to big government and big government spending per se.

The tax cuts are starting to increase revenue as expected. But there is anger and concern among many of the President's supporters because of his tendency to approve big spending items like the Medicare Prescription Drug law, the No Child Left Behind Act, etc. all of which represent huge increases in spending. Some of his supporters give him the benefit of the doubt by saying that he included free market incentives in the laws such as the Health Savings Accounts in the Medicare bill and the accountability rules in the NCLFB act and that the increases in spending were required to get these needed structural reforms passed. We will have to wait to see how he handles spending in his second administration before we can conclude whether the initial deficit from the tax will be a problem or not. But regardless, the tax cut is generating economic growth and the revenue to eliminate the initial deficit. The only question is will the administration and Congress use the money to eliminate the deficit or go on a spending spree.

Saturday, November 20, 2004

Tax Cuts and the Economy - Part 1 of 5

The following question was received from one of the students in the Economics 200 course:

From an economist's perspective, would you say President Bush's tax cuts were ineffective because of the huge deficit they created? Also they haven't seemed to stimulate the economy that much or create many more high jobs and the cuts were done during a war?

Here is my reply to this student:

This is a very good question. However, your question has three parts and I will answer each in a separate article. The three parts of your question are:

1. The budget deficits that resulted from the tax cut

2. The amount of jobs created as a result of the tax cut.

3. The quality of the jobs created.


The first thing to keep in mind is that tax cuts are as much political as economic, meaning that the President and Congress are just as concerned, if not more concerned, about the political as the economic effects of a tax cut. There are two main economic theories behind tax cuts: the Keynesian theory and the Supply Side theory. There are also two main political motivations behind tax cuts: increase government control of the economy or reduce government control of the economy. The economic theories are not necessarily mutually exclusive as was demonstrated when President Bush and some of his supporters used both Keynesian theory and Supply Side theory arguments when arguing in favor of the tax cut plan. The political motivations, however, are mutually exclusive in that the motivation must be for either increasing or decreasing the size of the government as you cannot do both at once. It is the political motivations behind tax cuts that divide Republicans and Democrats.

Let's start with the economic rationale for tax cuts and look at the two theories behind them.

The first theory is the Keynesian theory which views tax cuts as a counter cyclical tool of fiscal policy. Keynes focused his theory on demand and viewed demand as the key to managing the economy. Writing during the Great Depression of the 1930s, the problem Keynes saw was an economy faced with massive unemployment of both labor and the other factors of production. The problem, as Keynes saw it, was inadequate demand – people were out of work and and their purchasing power was sevearley restricted. With sales slow to non-existant, employers could not afford to hire people if there was no one to purchase their product. Classical theory stated that, in a free market, prices would fall to the point where people could afford to purchase the goods and wages would also fall to where employers could afford to begin employing people again. As the economy expanded wages would begin to rise as employers were increasingly forced to lure additional workers with the promise of higher wages. But the 1930s were not an era of flexible wages and prices. The economy was heavily unionized and union contracts would not allow wages to fall. Similarly, cartels existed in many industries and these acted to limit output and maintain price floors. Since normal free market mechanisms were not working, due mainly to unions and cartels, Keynes felt that the only way to pull the economy out of the depression was for the government to move in and act as the catalyst to get the economy going again (actually, it was government policy that provided the unions and industrial cartels with the power to enforce the wage and price floors). According to Keynesian theory, when the economy was in a recession or depression the government was supposed to step in and increase demand by:

1 increasing government spending (on things like building roads, public buildings, etc.) while not increasing taxes;

2 by cutting taxes while maintaining current spending levels; or,

3 a combination of increasing spending and cutting taxes.

Any one of these three courses of action would mean that the government was spending more than it collected in taxes and this would result in a budget deficit. But deficits were the goal of this policy as the objective was to keep government spending level or increasing while also increasing consumer spending.

Supply side theory stresses the need to increase supply by growing the economy. Modern supply side theory came into vogue during the 1970s and 1980s when the economy was expanding and demand was exceeding the economy's capability to produce goods and services to meet the demand. The problem was inflation, not depression. According to the theory, tax cuts were needed not so much to stimulate demand as to grow the economy. It was felt that tax rates were such that they were discouraging investment and work. Economist Arthur Laffer developed a curve showing that as marginal tax rates (see the October 10th posting on the Progressive Income Tax) increased they reached a point where they discouraged additional work and investment. By reducing the high marginal income tax rates government would let people keep more of the additional money that they earned – i.e., overtime income, income from a second job or income from a spouse going to work. People have to put forth a certain amount of work in order to support themselves, but, they will only work additional hours (overtime, second job, spouse going to work) if they see some reward in it. If the government taxes away most of the additional income people will have no incentive to put forth the extra effort. When existing workers work longer hours it is the same, in terms of production, as increasing the number of workers. For example, if ten people accept overtime assignments of four hours per week each (i.e., each worker works their regular 40 hours per week plus 4 hours of overtime) this is the same as adding one additional worker to the labor force. If one million people work an additional four hours per week that is the equivalent of adding 100,000 workers to the labor force – you can see that this could increase output substantially.



Note that after point 'X' on the graph, additional tax increases result in REDUCED revenues. If you are in the area to the right of point 'X' then REDUCTIONS in tax RATES will result in more revenue. But if you are to the left of point 'X' then reductions in rates will result in reduced revenues for the government.


In the next posting I will discuss the politics behind tax cuts.

Tuesday, November 16, 2004

Arbitrage

A take home test question in one of my four classes concerns the term arbitrage. In the text for the course the term is defined as "buying low and selling high".

Essentially arbitrage involves buying an item at a low price in one market and selling it at a higher price in another market. One of the roles of an entrepreneur is to identify items that are relatively scarce in one market (and hence have a high price) but are abundant in another market (as reflected by a lower price in that market). The arbitrageur then buys the product in the market with the low price and re-sells it in the market with the higher price. Obviously, this will increase the demand for the product in the lower priced market causing the demand curve to shift to the right and the price to rise. In the higher priced market the increased supply of the product that results from the entrepreneur or arbitrageur's action will cause the supply curve in that market to shift to the right causing the price in that market to fall. Eventually the two prices will converge and the price will be the same in both markets.

For arbitrage to take place there must not be any insurmountable barriers to the transaction. For instance, fresh lobsters are cheaper in the coastal areas of Maine than in Arizona. Restaurant owners in coastal Maine simply go to the dock and buy the lobsters from the returning fishermen. In Arizona the lobsters have to be packed and flown across the country causing the price to be considerably higher. But an arbitrage opportunity does not exist because the price difference is due to the shipping costs which cannot be avoided.

Generally, arbitrage opportunities arise due to lack of easy access to information and markets. But once these are overcome opportunities for arbitrage appear.

A decade ago the market for antiques and collectables was fragmented and localized. Potential sellers tended to be individuals with limited information about the market and too few items to justify the time and expense to seek out buyers for their items. Buyers also tended to be small collectors with limited resources. Enter eBay. With a few keystrokes and payment of a very nominal fee, sellers could advertise their wares to the world. With the same few keystrokes and no monetary cost, buyers could literally search the world for the items they desired. Prices were determined by demand and supply in this world wide market and everyone had immediate access to the latest price information in the market. Thousands of people found that items cluttering their homes were fetching high prices in other parts of the country and, for a nominal fee to eBay and a small shipping expense, they could reap a large profit on these previously "worthless" items. The result was an explosion in antiques and collectables with people first selling the accumulated clutter in their own homes and then, the more enterprising ones, branched out and began shopping garage sales, estate sales, local antique shops and auctions seeking items that could be sold for higher prices in other areas. It didn't take long for everyone to learn about eBay and the opportunities for profit. Today, most arbitrage opportunities in this market are gone as the market done its job of transmitting information and eliminating price differences between different areas for the same items.

Sunday, November 14, 2004

Supply and Demand Explained

Demand Curve – shows quantities of a good demanded (that will be sold) at various prices. The higher the price the lower the quantity demanded and vice versa.

Think of it this way, if you have $10 in your pocket and an item costs $10 you can afford to purchase one unit of the item. But if the price is $5 you can afford to buy 2, and if price is $2.50 you can purchase 4, etc.

Further, since there are more middle and lower income people than rich people, the lower the price the greater the number of people who will be able to afford to buy the product and the more people able to afford the product the greater the quantity that will be demanded.

Supply Curve – shows quantities of a good supplied at various prices. The higher the price the greater the quantity supplied.

No business (supplier of a product or service) can afford to sell at a price lower than cost and remain in business. BUT all suppliers of a good do not face the same set of costs. A farmer with fertile soil, a good climate and sufficient rain can produce a larger crop, at a lower cost than a farmer growing the same crop in poor soil in the desert. The desert farmer incurs the same costs for seed, labor, etc. as the other farmer. But the desert farmer must also purchase fertilizer, install irrigation and pay for water. As a result, the desert farmer will have higher costs per bushel of product than the farmer in the ideal location. In order to make a profit on his crop, the desert farmer has to receive a higher price per bushel than the other farmer. The point is that producers of a good or service face different circumstances and some are able to produce at a lower cost (require fewer resources) than others. As the price of a good rises more producers are able to offer the good or service.

As a second example, consider yourself and the sale of your labor services. If you had tickets to a concert for tonight and your supervisor asked for a volunteer to work overtime at the regular hourly rate you probably would not volunteer. If double time was offered, you might be tempted but the desire to see the concert would probably be greater. But, if your supervisor offered a $1,000 bonus to put in an additional four hours this evening, doing your regular work, you would probably take the offer. As the price goes up you, as the seller of your labor services, are more inclined to increase the quantity of labor you are willing to provide. In this example the cost is your opportunity cost. If you earn $10 per hour and your concert ticket cost $50 the decision to volunteer or not is a no brainer since you will lose the $50 spent on the ticket and only gain $40 from working the four hours. If your supervisor offered you double time (i.e., $20 per hour) for the extra four hours you would earn $80 and lose $50 for a net gain of $30. More than likely the desire to see the concert would be greater than the $30 of additional net income so you would probably still turn down the extra work. But $1,000 or $250 per hour, for four hours of work would probably change the equation as the opportunity cost of giving up the extra pay ($1,000) dwarfs the $50 plus satisfaction of attending the concert.

In summary, the demand curve shows the various quantities of a good that will be demanded (i.e., consumers are willing and able to buy) at various prices, while the supply curve shows the various quantities of a good that will be supplied (offered for sale by producers) at various prices. The point where the two intersect is the point where the quantity demanded equals the quantity supplied and this is the equilibrium or market price.


Equilibrium

Question: "If the equilibrium price of a product were $6 and the actual price charged in the market were $8, you would expect?"

Answer: There will be a surplus or excess of product on the market since the quantity demanded by buyers will be less than the quantity supplied by sellers.



In the graph above, consumers only want to purchase 15 units of the good at $8, while sellers want to sell 25 units at that price. We have a surplus, or overstock, of 10 units (25 available for sale minus the 15 people are willing to buy). Since sellers are in business to get money, they will compete to get rid of their merchandise and the best way to lure a buyer from a neighboring store is to offer the identical product at a lower price. Each will begin lowering their prices until all of the product is sold. Sellers who were forced to sell below cost will drop out of the market (or at least drop that product line) so long as the price is below the $8 which brought them into the market. The market will then stabilize at $6 which is the price at which the quantity supplied equals the quantity demanded.

Question: "A decrease in equilibrium price and quantity in a market will be caused by?

Answer: Both the supply curve and demand curve show how quantity demanded or supplied changes as price changes with all other influencing factors being held constant. But you and I know that price is not the sole factor in determining what and how much we buy or how we choose to sell our labor or any other product we may have.

The other Determinants of Demand are:

1 Consumer Tastes

2 Income level of consumers

3 Size of population (or number of consumers in market)

4 Prices of other goods, specifically substitutes (goods that can be used in place of the good in question such as buying lower priced chicken in place of steak) and compliments (good used in conjunction with another good such as hamburger buns and hamburgers).

The other Determinants of Supply are:

1 Technology

2 Input prices (the cost of the inputs, such as labor, raw materials, etc., used in the production of the product in question).

In constructing the two graphs used above, we assumed that the other determinants of demand and supply, listed above, remained constant while only price changed. However, these other determinants can, and do, change. When they change the result is a shift in the supply or demand curve.

For instance, the question "A decrease in equilibrium price and quantity in a market would be caused by?" can be answered by a change in one of the determinants of demand such as:

1 Taste – if consumers become concerned about the increased risk of injury and death posed by compact cars they will change their tastes or preferences for compact cars and many will switch to larger vehicles which they perceive as being safer.

2 Income Levels – if wages in Tucson drop across the board, local consumers will have less money to spend and they will want less of a product at every price.

3 Size of Population – if the Air Force decides to consolidate the functions of DMAFB with those of another base in another state and move all of the personal from DMAFB to the other state the population of Tucson will drop and so will the number of homes/apartments needed to house the remaining population. In this case fewer homes/apartments will be demanded at every price.

4 Prices of Other Goods – if the price of chicken at KFC, Church's Chicken, etc. drops while the price of hamburgers at MacDonalds, Burger King, etc. remain the same, many people will switch from hamburgers and substitute the lower priced chicken causing the quantity demanded of hamburgers to be less at every price.

In each of the scenarios above, a change in one or more of the other determinants of demand results in the entire demand curve shifting to the left and intersecting the supply curve at a new point where both the price and quantity are lower.



As you can see in the graph above, the demand curve has shifted to the left, from D to D1, the equilibrium price has dropped from P to P1 and equilibrium quantity dropped from Q to Q1.

If the opposite happens in any of the above determinants of demand (i.e., tastes change in favor of the product, incomes go up, population increases or prices of other substitute goods increase - i.e., prices at chicken fast food restaurants increase but those at hamburger restaurants don't, making hamburgers relatively cheaper than chicken offerings) then the demand curve will shift to the right signifying that greater quantities are demanded at each price.

Further, if one or more of the determinants of supply increase, that curve will shift. An advance in technology that results in reducing the cost of production (such as a new process for making steel from iron ore that results in a reduction in the cost of producing steel – this will lower the cost of steel thereby reducing the cost of producing things like cars which use a lot of steel). This will cause the supply curve for cars to shift to the right showing a larger quantity supplied at every price. Similarly, a drop in the price of oil will result in lower fuel costs for airlines and this means that the cost of flying airplanes will be lower. This would shift the supply curve for air travel to the right showing increased quantity (i.e., more flights) at every price. BUT, if the price of oil increases, this will raise the cost of flying airplanes causing the supply curve for air travel to shift to the LEFT indicating fewer flights (lower quantity) at each price.

Monday, November 08, 2004

Gresham's Law

Most introductory economics texts make some reference to the so called “Gresham’s Law which is usually stated as “bad money drives out good money”. What this means is that when two types of money have the same face value within a region but are valued differently outside the region, the one with the higher value outside will be horded and the one with the lower value will be used for spending.

You are probably thinking “why a country would have two currencies and why the currencies have the same value within the country and a different value outside the country”. The economist Robert Mundell in an article entitled “Uses and Abuses of Gresham's Law in the History of Money” gives the example of gold or silver coins which have the same face value (i.e., all the quarters are worth twenty-five cents each) but, due to wear, the older coins have slightly less weight so that when they are melted down the older coins yield a lower amount of the precious metal. For day to day transactions, a thirty year old worn quarter is just as good as a brand new quarter when put in a vending machine or given to the cashier in the store. But, if you go abroad and try to sell the coins for their metal content you will receive less for the old coins than the new ones since the old ones have lost some of their gold or silver content due to wear. Therefore, people who have access to buyers of gold or silver will save the newer coins when they receive them and spend the older ones.

An example of this phenomenon occurred in the United States about forty years ago during the 1960s when the price of silver began to rise. Up until that time dimes, quarters and half dollars were almost 100% silver (an alloy was added to increase hardness and decrease wear and this resulted in their not being pure silver). At this point the U.S. Treasury had the mint reduce the silver content by manufacturing “sandwich” type dimes, quarters and half dollars using a copper alloy center with a layer of silver on the top and bottom. Except for the copper colored center when observed sideways, the new coins looked and felt the same as their older silver counterparts. But the value of the silver and copper in the new coins was less than the face value of the coin (i.e., if you melt down a quarter the value of the resulting metal is less than twenty five cents) while the value of the silver in the old coins was worth more than the face value of the coin. The old, pre-1960s dimes, quarters and half dollars and the new, post 1960s dimes, quarters and half dollars are still legal tender and can be used interchangeably for purchases. BUT, all of the old silver coins have disappeared into coin collections or have been melted and sold for more than their face value. If you should be fortunate enough to encounter one of these old coins, which, look like the present ones, keep it as it is worth considerably more than the ten, twenty five or fifty cents exchange value in a store.

And, who was this Gresham fellow who postulated this law? Sir Thomas Gresham was a successful businessman and financial adviser to Queen Elizabeth I (1533 – 1603) who observed the phenomenon, like many before him, that when two currencies have the same face value at home but are valued differently abroad, the one with the higher value abroad will be horded and the one with the lower value used in exchange locally. While this had been observed and written about for twenty centuries before Gresham made the observation, it was Gresham whom the British economist H. D. Macleod referred when Macleod described the phenomenon in a publication in 1858 and named it “Gresham’s Law”.

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