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.

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.

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.

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.

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.

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!

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.

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.

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.

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.

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.

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.

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.

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.

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.