Thoughts on the Economic Crisis, III

The second part of this series concluded that a source of potential problem in a market economy is the monetary system. There can be too much or too little money, and each can cause problems. In this post, I want to examine the element of time and the financial markets that help cope with problems due to time.

We want to purchase goods and services today, but we also anticipate a similar desire a year from now. Just as trade-offs occur right now--I choose to play golf today rather than to go fishing--so can trade-offs occur over time. I can reduce consumption today, save, and increase my consumption possibilities in the future. Other things equal, current consumption is valued more than future consumption if for no other reason than the future is uncertain. A positive interest rate provides a trade-off between $100 of consumption today for more than $100 of consumption a year from now.

Businesses face problems when their receipts differ in timing from their expenditures. This is most obvious for a new firm. It may take several months of preparation, buying inputs, hiring workers, renting facilities, and so on before the firm has output to sell. The firm's owner must pay for these inputs, facilities, and workers prior to selling any output. The firm owner could have saved the funds to begin the firm, or the owner may be able to borrow some funds. Of course, the borrowed funds have to be repaid later. Even on-going firms often borrow short-term funds to smooth out the flows of receipts and expenditures over time.

Financial markets bring the funds saved by some to the borrowers. Financial institutions include commercial banks, credit unions, insurance companies, investment banks, among others. Another source of funds for businesses are equities, in which firms sell shares of ownership in the firm. Stock markets provide markets for "used shares," increasing the demand for new shares since the owner can sell them later.

Interest rates are the prices that equilibrate supply and demand for funds. If business prospects seem good, the demand for funds increases, which induces interest rates to rise. The higher interest rates provide an incentive for savers to increase how much they are saving. Interest rates reflect preferences of people for current consumption relative to future consumption, the productivity of capital, the relative scarcity of funds, expected inflation rates, and risk. The greater the risk of a borrower, the higher the interest rate the borrower will have to pay for a loan. Prices of financial assets are inversely related to the interest rate. For example, if the price of a bond that pays $1000 in a year is currently $950, the interest rate is (approximately) 5 percent. If the price of the bond increases to $960, the interest rate is now 4 percent.

Since the future is unknown, people have to form expectations about what the economic conditions in the future will be. Probably most people base future expectations upon the past, especially the recent past. Someone wanting to start a new firm must believe that there will be a market for the product in the future or it would be foolish to begin the new enterprise.

Finanacial markets rely on trust. Lenders have to trust that the borrowers will be able to pay them back in the future, and that the borrowers will fulfill their promises. A manufacturer that sells parts to another firm normally doesn't receive payment for a few weeks. The manufacturer trusts that the buyer will ulitmately make the payment. If a check is involved, there has to be trust that the check is good and will not bounce.

What can go wrong? Lots of things. Expectations may change due to new information. Trust can be broken, and if this happens enough, the system can seize up. Expectations may not be met. The demand for a product that an entrepreneur thought would be there when his or her production facilities came on line may not be there because consumer demand has changed, or because other entrepreneurs entered the market sooner. A bank that makes loans anticipates that some loans will not be repaid. If suddenly many more loans default than had been anticipated, the bank's position becomes riskier. It perhaps will reduce loans it is willing to make, making it more difficult for businesses to meet their short-term obligations such as payrolls. If people are laid off, they have a harder time making payments on their loans, which can further impact the bank negatively. If people see the future as riskier than they had previously thought, then interest rates will rise, asset prices fall, and a downward spiral can begin.

In my next post in this series, I will try to tie things together from the previous posts.

Negative Interest Rates Anyone?

According to an article in today's Financial Times, a Fed memo indicates that the best interest rate for the inflation/unemployment conditions today is -5%. Of course, a negative interest rate is not possible. The estimate of -5% comes from the Taylor Rule, which is a monetary rule that prescribes how a central bank should adjust its interest rate in response to macroeconomic developments. An article by an economist at the Fed explaining Taylor Rules can be found by googling Taylor Rule. Greg Mankiw had a piece in the New York Times on the need for a negative interest rate and how to achieve it. The fact that interest rates cannot literally be negative is part of the argument that the current situation needs fiscal stimulus.

Thoughts on the Economic Crisis, II

In my previous post, I concluded that given the complexity of the problem associated with the high degree of specialization of labor that prevails today, one might expect chaos to rule. Yet, it does not. In fact, when the economic environment becomes relatively more uncertain and chaotic, it is called a crisis.

Anyone who has had a basic economics course can recognize that we do not have persistent chaos because the market system functions well most of the time. The prices of goods reflect relative scarcities of goods and services. If people want more pencils than they had previously, the price of pencils increases indicating that pencils are now relatively more scarce. The higher price is a signal to pencil producers to find additional resources and produce more pencils. By doing so, their profits increase. The higher profits, if large enough and sustained enough, may even induce an entrepreneur to enter the industry and begin production of pencils. A natural disaster such as a hurricane that destroys homes and businesses creates a need for resources to be reallocated so that the area that was destroyed can be rebuilt. Again, price changes can provide the signals needed to induce people in other parts of the country to reduce consumption of materials and to induce building supply companies to increase production of lumber, shingles, and so on.

The term "invisible hand" is used to represent the process by which markets operate in an orderly manner. Another term sometimes used to describe markets and some other systems is spontaneous order. That is, order is arrived at spontaneously and not as the result of deliberate and planned actions of a group of people. The order achieved evolves over time through the development and evolution of institutions such as contracts, firms, non-profit organizations, co-ops, courts, government agencies, and so on.

But what about times of economic crisis? The market system would seem to take care of equilibrating quantities of demand and supply in most markets for goods and services. Price changes that signal changes in relative scarcity provide the correct information and signal. A natural disaster--hurricane, drought--can cause a problem for awhile, but the system should adjust over time. So, crises can be related to supply shocks to the economy. The bigger the shock the bigger the problem. Yet, if we just look at the real economy, the markets should correct themselves given some time. So, what else is needed to have a serious economic crisis?

Money is a complicating factor. The price signals mentioned above refer to "real prices" or to "relative prices." If the price of lumber increases, we mean to say that the price of lumber increases relative to the prices of other goods. But if there is money in the economy, then it is possible to have price inflation or deflation. If the inflation is anticiapted and if all prices go up by the same percentage, inflation should not add to the problem. However, that is not the way inflation works. Instead, some prices go up by more than others and the price changes come at different times and with different frequencies. Now if the nominal price of lumber increases 5 percent, it could be associated with a real price increase of 5 percent, or more than 5 percent or less than 5 percent. In fact, it could actually be a price decrease in real terms if all other prices are going up by more than 5 percent. The signal used in a market economy to indicate changes in relative scarcities is less informative in the case of inflation. People are more likely to make incorrect decisions because they interpret a 5 percent increase in the price of lumber as indicating that lumber is now relatively more scarce and should be economized more, when in actual fact it may be relatively less scarce. The more variable the inflation rate the more difficult it is for people to know what is going on in the marketplace.

We see then that an economic crisis can be related to incorrect monetary policy. This is not the end of the story though. We still need to consider the effect of time on the stability of a market economy, and this will be the topic of my next post.

Thoughts on the Economic Crisis, I

It's a financial crisis!
It's an economic crisis!
It's a failure of unregulated capitalism!
It's the end of the Reagan Revolution!
It's the worst since the Great Depression!

All of the above are statements one can hear describing the current economic situation. The use of the term crisis indicates that we are in a situation that is not normal. The third statement indicates that capitalism as practiced in the U.S. (as well as the U.K.) has failed because of lack of government oversight and regulation. The fourth statement suggests that the Reagan Revolution brought in unregulated capitalism and this has failed. The last statement is ubiquitous, but also indicates that things are really bad with the suggestion that things may get worse.

I want to examine things from a different perspective. Actually, I want to begin with Adam Smith and the key idea that specialization of labor is productive. What does this mean? At a minimum, it means that most of us produce goods or services that we do not consume or utilize and consume goods and services that we do not produce. This specialization is productive so that we can have much higher standards of living than if we were totally independent. In fact, most of us probably wouldn't survive long if we could only consume and use goods and services that we produced ourselves.

There are costs associated with specialization of labor. For one thing, the actions of different people need to be coordinated. If I don't make my own food, I have to rely on others to do so. All the things produced by producers are meant for consumers and the goods produced need to get to the consumers. The wants of consumers have to be communicated to the producers. Further, a form of exchange is needed. In a very simple economy, barter can be used. Another possibility is to have someone responsible for collecting all the goods and distributing them to the members of the simple economic system or society. When humans were organized in small tribes, this method may have been used. But, as societies get larger and specialization of labor gets more complex, these simple methods don't work well. Some medium of exchange--money--is needed. Adding money to the mix also adds complexity and potential problems. Is the quantity of money appropriate for the number of transactions that will be made. Who is responsible for producing the money? Who determines what money is? More questions could be added.

Another complicating factor is that we live in a world of space and time. Production takes time, whether we are talking about planting corn in the spring and harvesting it in late summer, or building a house. Further, some goods we produce are durable and provide services for a long period of time. Some goods are produced to increase future production but not for consumption. These investment goods include most of the capital goods in factories. A decision to start a firm to produce pencils involves purchasing inputs from many different parts of the world, building capital goods that are used to perform many of the steps in pencil production. (A description can be found in the interesting book, The Pencil: A History of Design and Circumstance by Henry Petroski. Available at Amazon.) To start a firm making pencils requires spending a lot of money to obtain the needed inputs, capital goods, and to support oneself while waiting to obtain revenues from pencils that will be sold eventually. This is where finance comes in. The people with the entrepreneurial spirit to start a new firm, the ideas that may be commercially viable are not always people who have savings to live off of while the plans come to fruition. Financial markets transfer funds from savers to investors. But, the investor may or may not succeed. The investor is counting on people wanting to buy his or her product in the future for prices that will cover all of the costs incurred by the investor. The future is unknown. Hence, many investment plans fail. Many new firms fail.

Given these complexities associated with specialization of labor and time, it would be easy to think that we would have chaos unless some very wise people were consciously and actively coordinating everything. That is, isn't it inconceivable that hundreds of millions of people can make decisions on their own about what to consume, where to work, what to make, what to save and invest, how many children to have, etcetera, etcetera, etcetera, could actually function? From this perspective, any situation that is not an economic or financial crisis would appear to be the abnormal situation. We should always be in crisis.

I will elaborate further in a later post.

Repurcussions of the Recession on State and Local Government

The economic recession impacts people in many ways. There are direct effects if one is laid off, owns a business that is seeing declining sales, and so on. The federal government sees a reduction in tax revenues and an increase in some expenditures automatically. These are called automatic stablizers and are in place to cool things down when the economy is booming and to stimulate the economy when output is falling. The federal government doesn't have a binding budget constraint so changes in income and expenditures don't have to match.
Things are different for most state and local governments. They usually have mandated balanced budget requirements, at least for operating expenses. State and local governments tend to rely on the sales tax as an important source of income. But, when consumers are not buying so much because of reduced incomes, sales tax revenues fall, leading to cuts in programs. The Wall Street Journal has an article today, in which it discusses the sharp drop in sales tax revenues impacting many states and local governments.

Association of Christian Economists

I leave tomorrow for the 25th anniversary meetings of the Association of Christian Economists at Baylor University. A colleague, Kim Hawtrey, and I are presenting a paper entitled, "The Socio-economic Ideas of the Emergent Church: Some Reflections." We look at two representatives of the emerging church movement (Brian McLaren and Steve Chalke and the economic ideas they espouse. In many ways they are reminiscent of the social gospel of the liberal protestant church in the early 20th century. Anyone interested in the paper can e-mail me at lunn@hope.edu and I will return a copy of it via an e-mail attachment.
I may not have much opportunity to write new posts while at the meetings, which go through Saturday.

Public Lands Management

I just received an e-mail message from PERC concerning President Obama signing the Ombibus Public Lands Management Act. Two members of PERC wrote a piece in Forbes criticizing the decision. Their article can be found here.

Is the American Consumer Becoming More Prudent?

Consumer credit fell in February, as reported in an article here. Accompanying the article is a graph showing consumer credit for almost 20 years. While reduced borrowing may be linked to reduced spending, and the government would like to see spending increase to help the economy pull out of recession, I think consumer credit needs to fall further. Households need saving to help during unexpected events such as serious car trouble, furnace going out, illness, layoff, and numerous other possible events. Further, longer-term saving for anticipated events such as buying a house, college education, and retirement is prudent. In fact, prudence needs to be emphasized in our economic life. Prudence is a term with a long history in economics. Adam Smith wrote of the virtue of prudence, and, more recently, Deirdre McCloskey describes prudence as, "...first in political and economic and bourgeois value." (Deirdre N. McCloskey, The Bourgeois Virtues: Ethics for an Age of Commerce. (Chicago: The University of Chicago Press, 2006), p. 253.) Perhaps the American consumer is becoming more prudent. Then again, it could be a short-term effect due to declining wealth and increased job losses.

Are the "Generals" Remembering History or Fighting the Last War?

The current economic and financial crisis has generated a lot of discussion about previous recessions as well as the Great Depression. Clearly, the approach taken by the federal government and many prominent economists is to take from Keynes the idea of government spending as a stimulus and replacement for reduced consumer spending and reduced business investment. There has been a lot of work over the past decades devoted to understanding the causes of the Great Depression and possible remedies. In this sense, people seem to be paying attention to the adage from George Santayana, "Those who cannot remember the past are condemned to repeat it." Yet, each crisis is different in the sense that the institutional structure of the economy is different, the international setting is different, and technology is different. It is often said that generals have a tendency to, "fight the last war." If we consider the post-World War II recessions as "police actions," then we may be fighting the last war rather than remembering history.

Changes in Mark-to-Market

The following is provided by my colleague, Martha LaBarge, Assistant Professor of Accountancy at Hope College. I have similar concerns that the current crisis will lead to a loss of independency of the Fed:

The FASB today approved two staff positions intended to provide additional
guidance regarding mark-to-market accounting rules. The results of both
positions will be to reduce writedowns of financial assets.
The first provides interpretation of the definition of fair value when no market exists
for an asset. The position defines criteria which allow assets to be
marked-to-model when the market is inactive instead of valuing assets at
fire-sale prices.
The second allows differentiation between asset impairments
due to credit loss and impairments due to other market factors. Credit
losses would still require a write-down which would hit earnings.
Market-related losses would, however, bypass the income statement and be
recorded in other comprehensive income.
Lawmakers pressured Robert Herz, FASB Chairman to act quickly when testifying before Congress mid-March. With only a fifteen day comment period, these changes
were adopted in time to be reflected in financial institutions’ first quarter
results.
Supporters argue that the writedowns under mark-to-market rules are
procyclical, causing earnings decreases and damaging capital ratios.
Investors argue that under the change, financial statements lack
transparency. While the “toxic assets” remain the same, their value may be
reported differently.
This move calls into question the independence of the FASB. Only three months ago the SEC decided mark-to-market standards had not contributed to the economic crisis and should not be suspended. The FASB has sacrificed clarity to the investor to pander to lawmakers and financial institutions. Former SEC Chairman,
Christopher Cox put it this way, "Accounting standards aren't just another
financial rudder to be pulled when the economic ship drifts in the wrong
direction. Instead they are the rivets in the hull, and you risk the integrity
of the entire economy by removing them."

Industrial Policy: Some Current Examples

Industrial policy is the attempt by government to direct the allocation of resources into particular areas. The Obama administration is formenting industrial policy, although it is not offering a specific plan labelled "industrial policy." Problems with industrial policy include the ability of government officals to know better than the private sector what new areas are likely to be economically viable over time, allocations may be based more on political influence than economic rationality, and unintended consequences.
The auto industry provides an example. Supposedly, General Motors and Chrysler are on short leashes to reorganize in a way acceptable to the government. The President has stated that he wants to see the American auto industry become a leader in building the next generation of clean transportation. Using government funds to push GM in that direction is an example of industrial policy. Do government officials have a better idea than people who have worked in the industry for years as to what technology will ultimately prove reliable, affordable and clean?
The auto industry, along with AIG, provide illustrations of unintended consequences. General Motors and AIG have competitors, and some of these competitors are not receiving funds from the government. In particular, Ford has not asked for government money. Yet, the government is giving funds to General Motors that may enable them to reorganize in a swifter fashion than would take place under Chapter 11, and may tip the competitive balance toward GM and against Ford. Competitors of AIG have said that AIG has used some of the money received to offer better rates on some product lines, tipping the competitive balance of power in favor of AIG.
It may be that GM and AIG are "too big to fail" and for the sake of the nation as a whole, the bailouts are necessary. I am not convinced, but it may be the case. Yet, the government actions and financial support have the potential of benefitting the firms who were losing the competitive battle in the marketplace and harming firms that were operating more efficiently and competitively. Government support alters the competitive balance.

Top Majors at Harvard University

Greg Mankiw's blog yesterday had a list of the top ten majors at Harvard. Economics is first by a wide margin over Government. There is a link to Mankiw's blog on this page if you want to check it out.
Since I speak some German and enjoy travelling to Germany, it is unfortunate that Germanic Languages and Literature is in the bottom ten majors at Harvard.

March Job Loss

ADP publishes a survey of the labor force prior to the official announcement by the government. The ADP survey has tracked the offical results closely most months. The March survey shows a loss of 742,000 jobs, which is more than many people thought or hoped. There had been some positive signs in the news--rising mortgage applications, retail sales levelling out, and sales of homes stabilizing. Normally, job loss or creation lags other indicators of the strength of the economy, but clearly the recent news suggests that the recession will continue into the near future.