Category Archives: Econ Geography

Solar Power Looking Brighter Economically

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John Quiggin of Crooked Timber sends us to Grist.org for “Solar Gets Cheap Fast” for good news about solar power.  The cost of producing solar photovoltaic cells (the silicon-based cells that convert sunlight to electricity) has been declining consistently at 20% per year since the early 1980′s.  Solar power is now close to the point where it is cost-competitive with fossil-fuel (coal, natural gas) and nuclear.  When we consider that any new coal-fired power plants will take 5 years or more to build (nuke even longer), then solar is now in the competitive horizon.  This is great news.

It really shouldn’t be news though.  We should have expected it.  Anytime a new product/technology goes into production, per-unit costs generally decline.  And, they generally decline at a predictable rate.  Two micro-economic phenomena combine to produce this predictable declining cost curve.  The first is often described in principles textbooks (although often over-stated):  economies of scale.  As production volumes get larger, often (not always) per unit costs decline because cheaper production technologies become feasible – it’s the phenomenon of mass production.  But another curve is involved.  It’s called an experience curve. Basically an experience curve summarizes how, even with using the same scale technology, as producers get more cumulative experience with producing the item, they produce it more efficiently.  In plain talk it’s called learning-by-doing.  It’s a staple of many business strategies, particularly in electronics.  While the specific improvements aren’t foreseeable ahead of time, the fact that costs will decline is predictable.  In other words, it’s predictable that we will learn.

Socially and economically, the arrival of wide-scale solar electricity generation is a good thing.  Solar electricity generation doesn’t create green house gases or other pollutants. It can be more effectively decentralized, relying less on huge power plants. The systems involved aren’t dependent on the kind of complex safety systems that make nuke power and coal dangerous. It doesn’t require a huge distribution and logistics network to mine/drill and transport a scarce natural resource like coal or gas.  And, solar installations can do double duty.  Unlike growing plants for bio-fuel or strip mining for coal, solar can be generated on top of existing buildings.   Critics often claim that solar is unreliable because “the sun doesn’t always shine”.  But solar system fit well with the demand for electricity.  Demand for electricity peaks in summer when the sun shines the most (think air conditioning). So the condition that creates peak demand for electricity is exactly the condition that generates solar power.  Further, newer solar systems are increasingly capable of generating electricity (albeit not as much) from just daylight even when bright sunlight is not present (does your solar-powered calculator stop indoors?).  Personally I’d rather trust the sun to rise each  day and provide daylight than to trust that engineers have perfect control of the safety of an inherently dangerous and polluting power plant (Fukushima anyone?).

The arrival of cost-effective solar power is also an object lesson in why government subsidies are often justified for new technologies.  Often, when new technologies are invented, the costs (“business case”) are too high to be practical or competitive with existing alternatives, despite the conceptual attractiveness.  We have a “new technology chicken-and-egg”.  Private investors and private firms won’t touch the new technology because it will take too long for costs to decline to a point where they can make the kind of high returns they want.  It’s too risky for them and too-long range.  Private investors and corporations really don’t think very long term.  But, until somebody actually begins producing the item we don’t gain the benefits of economies of scale or learning experience.  It’s at times like this that governments can play a great role.  Governments, by borrowing at the lowest interest rates, can take the long-run view.  They can invest because the benefits will be social and benefit the larger economy later.  Governments have, in fact, been key to creating new technologies and economic growth throughout the last several hundred years.  The telegraph, the telephone, electrical generation/distribution, canals, railroads, improved ocean navigation, computers, networks (including the Internet and World Wide Web that brings you this story), automobiles, aircraft and airlines — all these were dependent upon government early on and would not have happened had it not been for government.

That’s not to say government should always own, operate, and scale up the businesses that do it.  There’s a variety of mechanisms for government to seed and feed new technologies.  But that’s a different discussion.

U.S. Life Expectancy Falling In Some Parts

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I learned long ago when working in applied economics that averages (means or median data) often hide as much information as they impart.  To really understand an issue, we need to look at the variation or distribution.  Therein always lies a tale.  Yves Smith at Naked Capitalism (also the author of Econned), brings our attention to one such disturbing long-run indicator: life expectancy.  Despite the overall average life expectancy in the U.S. having risen significantly over the last decades, this longer lifespan is not evenly distributed.  In some counties in the U.S., life expectancy has been declining – and that was before the Great Recession/Workers Depression/Financial Unpleasantness.  (italic emphasis is mine; bold is from original):

Life Expectancy Fell in Many Counties in the US BEFORE the Crisis

A rising tide did not lift all boats even when the economy looked a lot better than it does now. As Francois T, an MD and medical researcher, wrote:

If you need ONE Indicator of how a nation is doing, it ought to be female life expectancy at birth. It is a tell tale sign that a lot of good things, (or bad things) are happening in the nation under study. … people severely underestimate the real repercussions and total costs of a decrease in female life expectancy at birth.

He pointed to a just-released study, Falling behind: life expectancy in US counties from 2000 to 2007 in an international context. Some of its major findings:

Large swaths of the United States are showing decreasing or stagnating life expectancy even as the nation’s overall longevity trend has continued upwards, according to a county-by-county study of life expectancy over two decades.

In one-quarter of the country, girls born today may live shorter lives than their mothers, and the country as a whole is falling behind other industrialized nations in the march toward longer life…

Some US counties have a life expectancy today that nations with the best health outcomes had in 1957 … Five counties in Mississippi have the lowest life expectancies for women, all below 74.5 years, putting them behind nations such as Honduras, El Salvador, and Peru. Four of those counties, along with Humphreys County, MS, have the lowest life expectancies for men, all below 67 years, meaning they are behind Brazil, Latvia, and the Philippines.

And get a load of this:

Despite the fact that the US spends more per capita than any other nation on health, eight out of every 10 counties are not keeping pace in terms of health outcomes. That’s a staggering statistic.

…

Yet looking at this map (click to enlarge), …

And remember, the data in this study goes through 2007. It will take a few years to find out what impact the crisis has had on the health of America’s citizens.

Life expectancy is strongly correlated with real income and socio-economic status within society.   Yes, from a medical standpoint, it’s smoking, type 2 diabetes, obesity, and hypertension that are what limit life expectancy (once child mortality is defeated).  But the incidence of smoking, obesity, etc. is all highly correlated with real income, status, and quality of health care.   Rich people generally don’t smoke, can afford to eat high-quality nutritious food, and get quality health care.  Poor people tend to smoke, get high-fructose corn syrup instead of nutrition, and get lousy health care, if any.

The U.S. simply doesn’t get value for money for all the money it spends on healthcare.  It’s the healthcare system that’s broken.

Can We Afford to Raise Taxes On High Incomes? Can We Afford Not To?

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Another tax related post.  It appears that taxes, in particular, taxes on the top income bracket will be a major topic of debate propaganda for the next year and  a half until the next presidential election.  Part of the reason is because the tax deal done last December (2010) between Republicans and Obama last December (2010) perpetuated the Bush-era tax cuts until Dec. 31, 2012, just after the election.  Another reason is because the Republicans in Congress, led by Congressman Paul Ryan have passed a proposed budget that will cut the top individual federal marginal income tax rate to 25%, ten points below the even the Bush-era 35%!  (source: Reuters)

The Republicans and Tea Partiers basically offer three arguments for cutting the top tax rates on high-income folks. None of the arguments hold up under examination.  First, they argue that the U.S. is too heavily taxed already. So, let’s compare the U.S. to other countries in the graph at the right from CBPP.  The U.S. is in fact, a relatively low tax country compared with other developed, industrialized nations.  (although to be fair, we should note that the other countries on the graph pay for healthcare for all their citizens and most of it comes from the government budgets).

So let’s move onto the second argument.  Republicans like to argue that cutting taxes for the top end, for the rich and high income brackets will create jobs.  They repeatedly call these high-end income folks the “job creators”.  Apparently out of some pique, these people refuse to “create jobs” for us lesser people whenever their tax rates exceed some number around 35%.  Unfortunately, this concept has been tried before and found wanting.  Simply put, there’s no empirical support for the idea that cutting tax rates primarily on the top end bracket will create jobs.  See here and here for more details. George Bush and the Republican Congress cut taxes and tax rates in 2001. At the end of the decade, in December 2010, the net increase in jobs (employment) in the U.S. was zero. That’s right. Not a single net new job.  No more people were employed in Dec 2010 than were employed before the tax cuts.  As I’ve discussed before, this doesn’t mean that Keynesian theory that cutting total taxes collected on from the nation has been disproven. Rather it means that how the taxes are cut matters.  Tax cuts only work to stimulate the economy and create jobs when they create new spending.  Tax cuts on the top brackets don’t create new spending, though.  They create a boom market in fixed luxury assets such as mansions in the Hamptons, Vail, or outside the country.  Tax cuts on the top brackets help fuel investments in off-shore funds and overseas entities, but they don’t really drive much spending here at home, at least not the kind of spending that drives good jobs and middle-class incomes.  Let us not make a mistake, while the Bush-era tax cuts included some minor cuts for lower income brackets, the overwhelming benefit accrued to the top bracket, as shown below (again from CBPP).  For more details and to see the real empirical record of tax rates vs job creation/economic growth, see Presimetrics, a site and book well worth the read.

Now let’s consider the third argument often provided as to why we need to cut tax rates for the top bracket.  Strange as it may sound, but the argument is offered that it’s the fair thing to do.  I know when you look at comparable average tax rates by income bracket like I did here and here, that it seems like the tax code is already quite fair to people earning a million dollars or more.  Yet their argument goes that it’s the richest people who pay for most of the government’s total taxes paid.  They cite the fact that the top income bracket people pay the majority of all tax dollars collected by the government.  That’s true.  But they neglect to say that it’s because the top bracket gets the dominant share of income in the U.S, not because the tax rate is too high.  Indeed, the top bracket payers are the only ones who have really benefitted in the last 30 years and seen their incomes grow substantially.  See the accompanying CBPP chart to see how the top 1% has seen it’s income rise 281% since 1979 (as it’s tax rates have been on a long down-hill slide), while the lower 80% barely grew 25% income.  The reality is that the top bracket pays the majority of tax dollars because they get the majority of the nation’s income.  Yes, the income distribution numbers are that out of whack.  The top 1% of households by income get a whopping 17.9% of all national income.  That’s just the top 1%!  Their share was only 7.5% 30 years ago.  (source: CBPP)So, actually the fair thing would be for the top bracket to pay a little more since they’ve benefitted the most from the current tax regime.

http://www.cbpp.org/images/4-13-11TopTenTaxCharts8.jpg

During the 30 year time frame that the top bracket has been raking in a larger and larger share of the national income while seeing their income tax rates decline, the lower brackets, the ones with incomes below $100,000 have seen their payroll tax rates double to build a giant Social Security trust fund.

Overall, I think we can afford to raise tax rates on the high income tax bracket.  In fact, if anything, there are good reasons to raise tax rates on the high end. First, since our government persists in it’s belief that it must borrow to finance a deficit (an unnecessary self-imposed constraint) and since many politicians, including those Republicans, think it’s a good thing to reduce the deficit (opinion I do not share), then we should.  As I observed with the post on the do-nothing plan, letting the Bush-era tax cuts expire and letting the existing law take force in January 2013 to raise the top tax bracket to 39%, which it was during the Clinton low unemployment years is a good plan. Let’s see what happens when if we allow the Bush tax cuts to expire and let the top rate go back to the 90′s era 39% vs. keeping the present 35% rate.  Again, CBPP obliges.

A strong argument can be made that the top bracket benefits disproportionately from the work of the government.  It’s not the poorest households that have investments in the middle east and around the world that are protected by the U.S. global military presence. It’s the richest. Time to pay the bill.

Libya, Tunisia, Egypt – One of These Is Not Like The Other

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Lately I’ve been puzzled about why NATO and the U.S. have intervened militarily in Libya, but stayed out of popular rebellions in Tunisia, Egypt, Yemen, Bahrain, and other middle east countries.  Human rights concerns doesn’t seem to fully explain it.  After all governments in Yemen and Bahrain in particular have violated human rights without so much as peep from the U.S.  Yes, there’s the oil explanation, but Libya doesn’t have that much oil (less than 2% of world exports) and besides Western firms (BP and Marathon) were involved in the production anyway.

Now comes a very interesting piece from Ellen Brown at Web Of Debt.  It’s the kind of thing that makes you go “hmmmm”:

If the Gaddafi government goes down, it will be interesting to watch whether the new central bank joins the BIS, whether the nationalized oil industry gets sold off to investors, and whether education and health care continue to be free.

Several writers have noted the odd fact that the Libyan rebels took time out from their rebellion in March to create their own central bank – this before they even had a government. Robert Wenzel wrote in the Economic Policy Journal:

I have never before heard of a central bank being created in just a matter of weeks out of a popular uprising. This suggests we have a bit more than a rag tag bunch of rebels running around and that there are some pretty sophisticated influences.

Alex Newman wrote in the New American:

In a statement released last week, the rebels reported on the results of a meeting held on March 19. Among other things, the supposed rag-tag revolutionaries announced the “[d]esignation of the Central Bank of Benghazi as a monetary authority competent in monetary policies in Libya and appointment of a Governor to the Central Bank of Libya, with a temporary headquarters in Benghazi.”

Newman quoted CNBC senior editor John Carney, who asked, “Is this the first time a revolutionary group has created a central bank while it is still in the midst of fighting the entrenched political power? It certainly seems to indicate how extraordinarily powerful central bankers have become in our era.”

Libya’s national central bank is not only not part of the BIS, the Bank of International Settlements in Switzerland, that regulates and coordinates international banking, but Gaddafi’s government has been actively promoting an alternative international currency and banking structure for African and Arab nations. The alternative currency and banking structure would greatly weaken the power of large, private international banks (largely U.S, British, and European) and facilitate popular policies in those countries.  Libya’s status as a non-member of the BIS is a status it shares with Iraq, Iran, Somalia, Sudan, and Syria.  Again, it just makes you go “hmmmm”.  I recommend following the link and reading the entire article here. 

Global Information Technology Report

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If you’re comparing countries economically (are you listening Comparative Econ Systems students?), you may want to check this report out.  It’s a global comparison of how countries have performed in adopting information technologies for the future.  As usual, Sweden and Singapore top the list.  It’s downloadable (pdf) and it’s comprehensive – 400+ pages.  Check it out.

The Global Information Technology Report 2010-2011

Sweden and Singapore continue to top the rankings of The Global Information Technology Report 2010-2011, Transformations 2.0, released by the World Economic Forum, confirming the leadership of the Nordic countries and the Asian Tiger economies in adopting and implementing ICT advances for increased growth and development. Finland jumps to third place, while Switzerland and the United States are steady in fourth and fifth place respectively. The 10th anniversary edition of the report focuses on ICT’s power to transform society in the next decade through modernization and innovation.

The Nordic countries lead the way in leveraging ICT. With Denmark in 7th and Norway in 9th place, all are in the top 10, except for Iceland, which is ranked in 16th position. Led by Singapore in second place, the other Asian Tiger economies continue to make progress in the ranking, with both Taiwan, China and Korea improving five places to 6th and 10th respectively, and Hong Kong SAR following closely at 12th.

The Global Information Technology Report 2010-2011

Aftershocks: Prepare for the Slowdown

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I’m back from the Higher Learning Commission conference in Chicago, which is why postings have been sparse.  I probably won’t get really back up to speed on postings for yet another few days because I’ve teaching, grading, and taxes to do.

In Japan, the aftershocks continue from the massive March 11 earthquake and tsunami.  The global economy is beginning to experience aftershocks from the triple disaster (quake-tsunami-nuclear meltdown) as well.  As readers might remember, I pointed out last month that the disaster would prove to be the first real large scale “stress test” of the concept of globalization in manufacturing.  The initial expectation of economists after the disaster was that it would prove a challenge and shock to the Japanese economy but that there really wouldn’t be much impact outside of Japan.  Now we are starting to see that this initial reaction was wrong.  We are starting to see aftershocks in the global economy.

The news for the last two weeks in the global auto industry has been about supply-chain interruptions and temporary plant closures. For example Forbes reports today on Toyota’s announcement:

Toyota Motor Corp. said today it is going to halt production in Europe for eight days due to parts supply shortages resulting from Marchs earthquake and tsunami.

The shutdowns will take place from April 21 to May 2.

Assembly plants in the U.K., France and Turkey will be impacted as well as engine manufacturing facilities in the U.K. and Poland.

The plants will then run at a limited capacity.

This is on top of earlier announcements of rolling temporary shutdowns at U.S. plants and the continued shutdown or slowed production at it’s Japan plants.  Other news reports today have Toyota advising U.S. dealers that there will likely be shortages of some models at showrooms this summer.  Other reports.

You can’t sell cars you don’t have and haven’t built.  And you can’t build cars without all the parts – less than 100% of the parts is just not enough. Phillipines, Japan, Turkey, France, U.S., Germany, Britain.  This is global. And it’s not just one company. It’s across the industry since most firms had all adopted the same globalized supply chain strategy built around single sources for key parts.

It’s also not just the auto industry. The Wall Street Journal reports how electronics manufacturers are being affected:

Over the weekend, the Nikkei reported that Sharp halted LCD panel production at its Kameyama plant in Mie Prefecture, western Japan, and at its Sakai plant in Osaka until after the Golden Week holiday season in early May. The paper cited disruptions to industrial gas supplies and said the company expects to secure more gas in about a month…

Sony said Friday it is suspending operations at its optical parts and IC cards plant in Miyagi prefecture in northeastern Japan, following a power outage caused by the biggest aftershock to hit the area late Thursday.

A Sony spokeswoman said the plant will resume operations as soon as the power supply has been restored.

“Electronics makers and auto makers are extremely sensitive to further damages as it is becoming increasingly unclear how soon companies can resume full production,” Watanabe said.

I think it’s safe now to say that Japanese earthquake-driven interruptions to supply chains are more than just a “risk” to the global economic performance. We should consider the interruptions and concomitant plant shutdowns as a factor currently slowing economic growth.  At this time, the big question is just how much they will slow growth and even potentially reduce employment.

As I’ve mentioned previously, I have no great (or little) econometric model that I use.  I just go on my intuition.  Right now, I’m thinking the supply chain interruptions reduce GDP growth in the U.S. in second and third quarter 2011 by maybe 0.2-0.3 percentage points.  That’s not much. And in normal times it could be easily absorbed.  But this is not normal times.  We only grew at 2.9% in 4Q 2010.  We won’t know 1Q 2011 growth for another two weeks, but estimates are running lower – in the 1.5 to 2.5% range.  We need growth above 4% if we are to make serious inroads on re-hiring the nearly 20 million unemployed people, so, yes, this hurts.

And, like all aftershocks, this one is not isolated. There’s other aftershocks starting to hit our economy. Aftershocks from misguided budget deals and misguided European monetary policy.  I’ll talk more about those as I get time. Unlike GE, I have to pay my taxes this weekend.

Innovation in Monetary Policy in Sweden Works: Negative Interest Rates

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The Sveriges  Riksbank (a.k.a.  Riksbanken), the Swedish central bank, tried an innovation in monetary policy two years ago in July 2009 when it set the official deposit rate at a negative interest rate of -.25%.  The objective was to stimulate and motivate banks to lend their “excess” reserves to businesses and households and to therefore stimulate the economy.  The Riksbanken was the first central bank to try a negative interest rate and as far as I know, it’s the only one that has tried it.

The results of the experiment look pretty good.  The Financial Times has reported that Sweden’s economy has come roaring back from the depths of the global recession.  It recorded a 7.3% growth in real GDP for 4th quarter 2010 (year-over-year). Fast enough growth that the bank has long since found it necessary to raise interest rates back into positive territory.

So what happened here? And how does a “negative interest rate” work?  Monetary policy is primarily handled by changes in interest rates. In particular, central banks change interest rates on their dealings with commercial banks in their country.  Remember a central bank is a “banker’s bank” – it’s where your average ordinary bank, be it JP Morgan Chase or Podunk Community Bank, has both deposit accounts and loan accounts.  The average commercial bank keeps a certain amount of money on deposit at the central bank. This is what are called “bank reserves” (technically currency in the vault also counts as “reserves” but it’s minor statistically).  Reserves are used to handle transactions with other banks (customer checks to be cleared) and, sometimes, as a cushion for safety. In normal times when the economy is growing and there are plenty of credit-worthy people to lend money to, a bank wants to hold only minimal reserves.  In fact they want to hold only enough to handle any withdrawals such as clearing checks to other banks.  Historically banks would be required to keep a certain % of their deposits as “reserves”.  However, in many nations that’s no longer true (Canada, Japan, Australia).  It’s partly true in the U.S. where demand deposits (checking accounts) have a minimum reserve requirement, but not true for savings deposits.  The reason banks don’t normally want to hold reserves is because they can make more profit by lending the money out.  But lending is only attractive (read highly profitable) in normal times.  In times of crisis, recession, and panic credit-worthy customers are harder to find.  Banks raise their lending standards and become more focused on security/safety instead of making more loans.  So the amount of reserves tends to rise as the banks are reluctant to lend the money.

So banks have deposit accounts called “reserves” at the central bank.  But banks also can borrow from the central bank when they want or need more reserves.  The central bank can arbitrarily set the interest rate for both of these, the deposit (reserve) accounts and the loan accounts (discount loans).  Historically, the Federal Reserve Bank in the U.S. has only set an interest rate on the loans to banks – this is the “discount rate” and it’s set by the Fed Board.  (it’s closely related to the “fed funds rate”, but that’s a whole other story).  Again, historically the Federal Reserve Bank never paid interest on the reserve accounts.  They required banks to keep them, but wouldn’t pay interest on the deposits.  That changed in October 2008 when The Fed finally did what others have long done and took the new step of paying interest to banks on the reserves they keep on deposit at The Fed.  I believe the current rate is 0.25%.  Not much, but when figured on hundreds of billions of dollars that are just sitting there securely at The Fed, it’s a nice source of profits to banks.

Therein lies a problem.  In the crisis banks accumulated very large reserves. Reserves are now much greater than what the need for transactions suggests.  In effect, banks are simply sitting on the money.  They have the funds to make loans but choose not to. Instead, they choose to let the reserves sit idle rather than loan them out.  It’s a nice deal for the banks.  Nice safe profits with no risk. But it’s a problem for the rest of us.  We need a growing economy. And a growing economy needs consumers and businesses to spend more.  Consumers need to buy more and businesses in particular need to spend more on investment and expansion if we are to create jobs and grow the economy.  Problem is, businesses and consumers aren’t getting the loans they need.  Why?  In part because banks want to sit on the reserves.

The solution?  Obviously we need to lower the interest rate paid on the reserves so that banks would choose to make loans (at least constructive loans, not just loans to buy derivatives) in larger volume again.  Well with an interest rate as low as 0.25%, one-quarter of one percent, it’s hard to go much lower.  Or at least that’s what economists and central bankers have long thought.  We thought there was a “zero lower bound” which fancy talk for “interest rates can’t be negative”.

Now we return to Sweden.  The Swedes at the Riksbanken thought “outside the box”, or at least outside the “lower bound”.   They lowered the interest paid on bank reserves deposited at the Riksbanken to a negative number: -0.25%.  In effect, Swedish banks now had to pay the Riksbanken for the privilege of keeping the reserves at the central bank.  As their chair explained, it was, in effect, like having a penalty tax on holding extra reserves.  The idea was to motivate banks to reduce the level of reserves to what they really needed for transactions and take the rest and lend it.  By lending it, it would lower interest rates charged to business and consumers (‘banks compete, you win!’). Businesses and consumers take their new loans and spend the proceeds.  Spending makes sales at businesses. GDP grows. People get hired.  The economy recovers.

It worked. Dramatically.

And it worked.  Sweden’s growing now at over 7%.  They’re now concerned about how to keep the economy from overheating.  We in the U.S. should be so lucky.  Instead we’re still stuck with anemic growth of around 3% despite unemployment of near 9% or more.  Both the government and Federal Reserve continue to be concerned with the health of the banks – whether they are profitable enough and have enough reserves.  We’re worried about helping banks, but nobody is willing to make the banks help the economy through the right incentives.

The challenge getting an economy to recover and grow again after

‘Ism’s, Rhetoric,and the Branding of Ideology in the 21st Century

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The following is a reflection I’m sharing with my online Introduction to Political Economy (it has a different name, but that’s what it is) course. It’s long and therefore continued after the jump.

Textbooks and politicians make frequent use of labels for socio-political-economic systems. Typically these labels identify some particular ideology as an “ism”.  Thus we have capitalism, socialism, communism, fascism, and probably several others I’ve missed. For those that grew up in the 20th century or have been educated by those who grew up in the 20th century, it seems natural. We talk about the merits of socialism vs. capitalism for example as if we were discussing the merits of alternative selections from a menu.  It hasn’t always been this way, though.

In the middle and dark ages people did not discuss or promote “feudalism”.  In fact, the term itself is an invention of scholars in later centuries. (see fascinating article on how feudalism as we think of it didn’t really exist).  The term, “feudalism”, is a construct, a rhetorical device, created to guide us into thinking about the socio-political-economic system of that era. In earlier times, those people who discussed political and economic policy issues focused primarily on the specifics of the issues in front of them at the time.  Policy decisions were made on an ad hoc, practical basis.  They essentially are today also, but since the 19th century, we don’t always think of policy that way.  There is a tendency to think there is a master plan or grand design or some kind of over-arching principles which can be used to guide our specific decisions.  We think that policy makers are (or should be) guided by these principles in making policy.

The Role of Media in Creating Manifestos, Platforms, and Slogans

Part of the reason, perhaps the major reason, why we think this way is because popular elections have made it necessary. In the pre-democratic past, back before the French or American revolutions and before the franchise was expanded in England, only a few people, the power elites such as kings, lords, landed gentry, their advisors, high clergy, and some academics need be concerned with policy. They were the only ones whose views mattered. But as popular elections and democracy began to spread, starting in the 18th century and continuing into the 20th century, the views of the populace at large began to matter. It became increasingly important for policy questions to be debated and understood by larger and larger numbers of people.  Increasingly, these people had less background and less time to understand the “nuances” or specifics of policy.  A farmer on the frontier or a worker in a factory may have been smart and literate, but they had little time or resources to spend researching and considering policy options before voting.  Even for the well informed, they had little influence beyond the voting for particular candidates. Their specific views on particular subjects were (and still are) irrelevant. Their only choice was between the candidates presented. Continue reading →

What’s A Derivative?

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A colleague (non-econ) asks: What’s a “derivative” in plain terms?  The plainest answer, yet not very helpful, is that derivatives are a Wall Street cross between the Frankenstein  monster and the blob: they’re a banker-made monster that’s out of control and swallowing the global economy.

But let’s look at derivatives in a less inflammatory way.  Derivatives are a very broad class of financial contracts (also called securities) that depend on some other financial contract for their value.  That “other financial contract” is called the underlying security. Before we get to derivatives, though, let’s look at the most basic “underlying securities”, or what we consider “fundamental” financial contracts or securities.  These include stocks in companies (also called equities), debt contracts (mortgages or bonds), commodities contracts (purchase of actual physical things such as wheat, oil, gold, etc), and foreign exchange (purchase some other currency with a different currency).  These are the contracts that most people think of when they think of Wall Street. These are transactions where something of value in the real world is being bought/sold. When fundamental transactions happen, ownership of something real changes hands for a price.  Example: you buy 100 shares of Acme Rockets stock at $20 per share. You pay $2,000 to the seller now and you get 100 shares of ownership of Acme Rockets.  What determines the price of an underlying fundamental security? Well it’s supply-and-demand, who wants to buy it and who wants to sell it and for how much.  But there’s an underlying real-world economic logic to the valuation over the long-haul.  Over the long-haul, today’s price of a stock should be related to the future profitability and growth of the company. The price of bond today depends on the interest rate the debtor pays, how long to maturity, etc. Same for a mortgage. Today’s supply-and-demand for real-world physical oil or wheat determines today’s “cash” price for delivery of those commodities now. When a fundamental contract transaction (equity, bond, commodity, or foreign exchange) happens, the price is set, the deal is done right now, and it’s over.  It’s just like buying milk at the store today. Go through the check-out line, pay the money, get the milk, done deal.

In contrast, derivatives involve promises about future transactions. A derivative contract involves a promise by one party, the contract seller, to deliver or sell some other financial contract in the future at a price that is fixed now.  The promised contract is called the “underlying security”.  The original class of derivative contracts were called futures contracts and options contracts. Both have some valuable uses in the real world, but both can be prone to abuse.  The idea is generally to manage the risk of some future price movements in the underlying security. Let’s look at a couple examples.

Example 1: Suppose a farmer, we’ll call him Curly, has corn planted on his farm. It’s May.  Based on his experience he expects to harvest and sell x bushels of corn next September. Right now, in May, the price of corn is relatively attractive.  Let’s say the cash delivery price for corn in May is $100. Curly’s afraid that when September comes, the price will drop. He wants to lock in the current price and make his life predictable and less uncertain. Curly sells a futures contract for September delivery.  In other words, Curly sells his promise to sell in the future.  The futures contract itself sells for maybe $1.  In other words, Curly gets $1 to get him to promise to sell at the fixed price of $100 in Septemeber no matter what cash prices are in September. Who would buy such a promise? Well maybe it’s Kellogg’s who wants to nail down the future price of raw materials. Or maybe it’s a speculator like Larry. He sells the contract to Larry. The contract establishes that Larry, the buyer/owner of the futures contract, promises to pay $100 for x bushels of wheat in September and that Curly promises to deliver x bushels at pre-determined spot for $100 in September.  The contract makes sense to Larry since he expects corn to be selling for $104 in September and he plans on taking the delivery at $100 and immediately selling it for $104.  If Larry is right, then he spends $1 now in May and makes $4 in September.  He triples his money with very little actual cash involved up front. Of course, if Larry is wrong and the September price is $98, then he’s out the original $1 for the contract and he’ll lose $2 on the corn in September. In effect, Larry is making a bet on the future price of the fundamental commodity price in the future.  A futures contract is a derivative. Larry could sell his futures contract to yet a third party, say Moe, in July if wants. Then Curly must deliver to Moe. The present price of a futures contract is (in theory) determined by the price movements of the underlying security.

Example 2:  Stock Options. Suppose Groucho, a stock market speculator, thinks that Acme stock is going to rise from $100 per share to $120 a share in the next year. Groucho only has $10,000 in cash right now. He could buy 100 shares at $10, wait, then sell for $12. He makes a $2.000 profit, or 20%, in one year.  But Groucho doesn’t care about actually owning the company, he’s only interested in stock price movements. So instead of buying the stock itself (the underlying security) he buys an option contract.  The option contract says Groucho has the right, at his choice, to purchase Acme stock for $100 per share at any time for the next 12 months from a particular seller. Who would sell a contract like this? Well suppose a pension fund already owns lots of Acme stock. The pension fund doesn’t think it will rise that high, or if it rises that high then they want to cash out and take their profits. The pension fund sells the options contract to Groucho at a price of $0.50 per share.  So Groucho puts his whole $10,000 into the options contract.  He buys the right to buy 20,000 shares at $100 in the future from the pension fund.  Suppose the price only rises to $110 instead of what Groucho thought it would do.  Nonetheless, he “exercises” the option. That is, he forces the pension fund to sell 20,000 to him at $100.  He simultaneously tells his broker to sell the 20,000 shares in the open market at $100.  Groucho makes 20,000 times $10 difference in price = $200,000 profit. But of course the original options contract cost him $10,000.  He turned his $10,000 into $200,000.  Nice return. Stock options are like highly leveraged betting on future stock prices.

So derivatives are financial contracts based upon some other financial contracts.  The current price or value of a derivative contract should be rationally derived from the prices of the underlying securities, hence the name derivatives.  In practice, though, derivative contracts allow large numbers of people with large sums to make “bets” on the future price movements of underlying securities.

When this old man was in the brokerage business 35 years ago, futures contracts and options contracts were pretty much the extent of derivatives.  The biggest players were usually firms with legitimate needs to nail down future prices and limit real-world risk. Economics Blog explains as:

How and why do firms use derivatives to hedge risk?

Financial derivatives are a mechanism for managing risk. They involve options to buy or sell at a certain price in the future. This means that a firm can guarantee being able to buy or sell a contract at a certain price.

But that’s all changed today.  Wall Street has expanded the scope and nature of derivative contracts beyond any real-economic needs.  Huge sums are now involved with huge leverage. Wall Street is now a huge global casino.  There are now derivatives contracts such as:

  • CDS: Credit Default Swaps – bets on whether some bonds/companies go bankrupt. Buy a CDS along with the bonds you buy and you insure yourself against the debtor going bankrupt. Or skip the bonds completely and simply bet on whether the company will go bankrupt.  The large number of CDS’s on GM bonds in 2009 was one reason why it was impossible to work-out a rescue or restructuring of GM and bankruptcy was the only option.  Major banks and funds who owned GM bonds also owned CDS’s and profited from the bankruptcy, as I predicted before the fact. See also here.
  • MBS: Mortgage Backed Securites – The infamous bonds sold who derive their value from the payments received from a pool of home mortgages.
  • Collateralized Debt Securities – bonds based on the value and cash flow of a pool of other debt contracts such as consumer credit card accounts or car loans.  It’s not the loans themselves, but it’s based on the cash flow of the loans.
  • Interest Rate Swaps – bets on the future movements of interest rates
  • Exchange rate swaps – promises to deliver foreign currency at fixed rates at some future data – a bet on exchange rate movements.

The sums are beyond astronomical now.  The world’s total GDP, the total value of everything of real economic value that the entire planet produces each year is in the neighborhood of $65-75 trillion each year.  But 2-3 years ago when the global financial meltdown started, the total value of all existing derivative contracts world-wide was estimated at over $600 trillion.  In oil alone, the total value of all oil futures contracts, if they were actually exercised and resulted in delivery of oil, would require more than 6 times the amount of actual oil we produce.

The derivatives markets are now pure gambling. A casino on a global scale. And like a casino, it’s rigged. It’s possible some individuals to win big. But it’s also possible to lose really, really big.  The house, however, never loses. The global banks that create and operate these derivative contracts and markets, the Goldman Sachs, JPMorgan Chases, Citis, BoA’s, etc. can’t lose.  Heads, they get management and broker fees plus profits.  Tails, they get management and broker fees and the taxpayer or central bank picks up the tab for the loss.

Possible Economic Effects of Japanese Disasters

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Some information is starting to develop about the economic impacts of the events in Japan.  A week ago, just after the triple disasters of earthquake, tsunami, and nuclear plant partial meltdown, it was much too difficult to foresee the probable impacts of the crisis. Now it’s starting to show and the news is not encouraging for a world that was only engaged in a weak precarious “recovery” from the Global Recession/Global Financial Crisis.

This crisis is really going to be a “stress-test” of modern globalized supply-chains.  The growth of world trade, particularly trade with and within Asia in the last 2 decades has been less about traditional trade, the buying and selling of finished goods between independent agents in different countries.  Instead, “globalization” is increasingly about extended specialization that stretches production processes around the globe. In traditional trade, a disruption of supply from one region is quickly substituted by other products from other regions. Thus traditionally, a natural disaster in one area tended to harm the economy of that region but not have ripple effects elsewhere.  Now, with globalized supply chains for complex designed products like consumer electronics, automobiles, industrial equipment, and computers, a simple disruption in one region might require the shutdown of production in far distant regions as parts become scarce.  Parts of sub-assemblies are usually design-specific and cannot be easily replaced by other sources.

We’re seeing the early signs of such problems.  Last week GM announced the temporary shutdown of an assembly plant in Shreveport, LA due to a lack of parts from Japan.  The NYTimes and WSJ report, via Calculated Risk, that in Japan itself, while Nissan has announced the first re-start of an entire auto assembly plant, resumption of full production at Japanese automakes remains uncertain.  Honda has warned that full production may not restart until May.  They also report that GM has had to curtail production at at least 2 plants in Europe in Spain and Germany. Now today, USA Today reports that the GM shutdown in Shreveport has rippled back to Tonawonda, NY, where GM makes engines for the pickups that are hung up pending Japanese parts.  More on the Japanese struggles to recover at the NYTimes.

Right now, many economists, particularly investment bank economists are saying the risks to global growth are minimal.  But much of their argument is based on the past and the experience with the Kobe earthquake in Japan in 1994.  I’m not so sure.  For one thing, the global supply chains are much more complex and tightly integrated now than they were after Kobe.  It’s not just autos. It’s also a lot of other industries and production spread throughout east Asia such as Hong Kong, Taiwan, Thailand, and Korea.

Another very serious factor is how fast electrical power generation can be restored.  The Economist quotes Richard Koo:

the country as a whole might have suffered about a 12% decline in its capacity to supply electricity. Since the elasticity of electricy usage to GDP is about 2, this means that Japan’s GDP might have shrunk by as much as 6% in the wake of this disaster. Although efforts to improve electricity supply are on the way, even a momentary GDP decline of 6% is a huge shock to the economy.

I’m inclined to agree.  Electricity capacity is not quickly restored if the entire plants are scrapped as is happening with Fukashima, the site of the destroyed nuclear reactors.  This could mean a very deep contraction for Japan with a slow recovery. A 6% decline in the third largest GDP in the world and one of the most active trading partners would be a very serious dent in the world economy.  Especially at a time when Europe is struggling to grow because of it’s Euro-strait jacket monetary system and growth-reducing austerity policies.

Here in the U.S., we are facing our own threats to this very anemic “recovery” in the form of deeper state and local government spending and employment cuts.  We are also facing the prospect of higher gas prices for a protracted period which will also slow the economy.  I had hopes that the Japanese disasters, by slowing the Japanese economy, might at least weaken global demand for oil and possibly temper the recent rises in prices. But, alas, with the weekend decision to bomb Libya, oil prices have once again begun to rise.