Economics help blog – Page 97

It is OK to be selfish?

12 March 20189 March 2018 by Tejvan Pettinger

With my new book – What would Keynes do? – The brief was to write essays on how famous economists would respond to everyday questions. So for example, for the question – Is it OK to be selfish? I examined how the likes of Adam Smith, Karl Marx, Arthur Pigou and Alfred Marshall might answer this …

Minimum price for alcohol – pros and cons

1 June 20189 March 2018 by Tejvan Pettinger

A minimum price for alcohol means that alcoholic drink cannot be sold below a certain price. It is aimed at preventing the sale of very cheap alcohol by supermarkets. The hope is that a higher price will discourage binge drinking, improve health, and make people pay a price closer to the true social cost of …

Effect of US steel tariffs

7 March 20187 March 2018 by Tejvan Pettinger

What would be the impact of the US placing a tariff on the import of steel and aluminium into the US A tariff on imports of foreign steel would raise the price of imported steel and encourage US firms and consumers to buy domestically produced steel instead. At the moment, American producers find it cheaper …

New book – What Would Keynes do?

3 October 20186 March 2018 by Tejvan Pettinger

What Would Keynes do? This is a book which examines how famous economists might answer 40 different everyday questions about life What Would Keynes Do? will help you get to grips with economic theories in an original and thought-provoking way. *** The book was a lot of fun to write as it involved examining a …

Do trade deficits cause unemployment?

5 March 2018 by Tejvan Pettinger

A trade deficit occurs when the value of imports of goods and services is greater than the value of exports. For example, in 2016 the US exports totalled US$ 1,450,457 million. Imports totalled US$ 2,248,209 million. (WITS) Source: Trade balance at St Louis Fed. Since 1990, the US has run a persistent trade deficit. The …

Customs Union – advantages and disadvantages

1 April 20192 March 2018 by Tejvan Pettinger

A Customs Union occurs when a group of countries agree to have free trade amongst themselves and agree on a common external tariff to countries outside the zone. It is a step towards a single market, but a customs union doesn’t include freedom of movement for people and goods. A customs union is often examined …

Financial Instability Hypothesis

7 May 202012 February 2018 by Tejvan Pettinger

The hypothesis of financial instability was developed by the economist Hyman Minksy. He argued that financial crisis are endemic in capitalism because periods of economic prosperity encouraged borrowers and lender to be progressively reckless. This excess optimism creates financial bubbles and the later busts. Therefore, capitalism is prone to move from periods of financial stability to instability. This is a type of market failure and needs government regulation.

Financial Instability could be summed up as:

Success breeds excess which leads to crisis

Economic stability itself breads instability.

Since the credit crisis, many have looked back at the Great Moderation (a prolonged period of economic growth during the 1990s and 2000s) had examined how it contributed to complacency and risk-taking.

How economies go from stability to instability

Traditionally, bank lending is secured against assets. The lending is hedged against default. For example, banks lend mortgages if people can raise a deposit and can maintain mortgage payments to repay both the capital and interest. Typically banks would also check strict lending criteria to make sure the mortgage is affordable.
However, if house prices rise and there is economic growth, both lenders are borrowers become more optimistic and willing to take on greater risks.
Banks insist on smaller deposits and are willing to lend bigger multiples of income.
Lending becomes more leveraged.
The greater lending itself causes asset prices to rise and this increases confidence even further. People keep expecting rising prices – the past becomes the guide to the future.
We could term these sentiments as ‘Irrational exuberance‘ There is a feeling that the crowd can’t be wrong. If everyone expects asset prices to keep rising, it’s easy to jump on the bandwagon.
Rather than hedge borrowing (safe secured lending) we see a growth of speculative lending and even ‘Ponzi borrowing’. This means banks and financial institutions lend money in the hope that asset prices keep rising to enable repayment. However, the loans of a Ponzi nature are unsustainable in the long term.
Regulatory capture. Regulators who should be insisting on safe lending levels also get caught up in the irrational exuberance. Credit rating agencies make mistakes in allowing speculative and Ponzi borrowing.
However, this asset bubble and speculative lending cannot be maintained forever. It is based on the unreasonable expectation that asset prices keep rising beyond their real value. When asset prices stop rising, borrowers and lenders realise their position has left them short – they don’t have enough cash to meet their repayments. Everyone tries to liquidate their assets to meet their borrowing requirements. This leads to a loss of confidence and credit crunch.

Minksy Moment

The Minsky moment refers to the point where the financial system moves from stability to instability. It is that point where over-indebted borrowers start to sell off their assets to meet other repayment demands. This causes a fall in asset prices and a loss of confidence. It can cause financial institutions to become illiquid – they can’t meet the demand for cash. It may cause a run on the banks as people seek to withdraw their money. Usually, the Minksy moment comes when lending and debt levels have built up to unsustainable levels. It can lead to a balance sheet recession

Keynesian economics

27 February 20205 February 2018 by Tejvan Pettinger

The essential element of Keynesian economics is the idea the macroeconomy can be in disequilibrium (recession) for a considerable time. To help recover from a recession, Keynesian economics advocates higher government spending (financed by government borrowing) to kickstart an economy in a slump.

Keynesian economics includes

Disequilibrium in macroeconomy (insufficient demand)
Imperfect labour markets (e.g. sticky wages)
Paradox of thrift (in recession, individuals save more, but this worsens the economic downturn
Liquidity trap. When low-interest rates fail to boost demand.
Importance of confidence to the economic cycle.
Deficit spending. In a recession, Keynes advocated government borrowing to provide an injection of demand into the economy.

What Keynesian economic is not

Keynes did not advocate a Socialist state, where government-controlled the means of production
Keynes did not advocate allowing higher inflation. During periods of growth, Keynes argued inflation should be kept under control.
Welfare State. Keynes did not necessarily advocate higher government spending as a % of GDP. He argued spending should increase only in an economic downturn.

Theory behind Keynesian economics

1. If saving exceeds investment, we get a recession

Classical theory suggested any fall in investment would lead to lower interest rates; this fall in interest rates would reduce saving, increase investment and cause the economy to return to a new equilibrium of full employment. However, Keynes’ analysis suggests this is unlikely to occur, due to a number of factors, such as a liquidity trap and the general glut of savings.

Why Keynes felt recessions could last a long time

Liquidity Trap. A liquidity trap is when low-interest rates fail to boost demand. For example, if confidence is very low, people won’t borrow – even though it is cheap. Also, very low-interest rates can make banks unprofitable, so they reduce lending.
General glut. If saving is high and consumer spending low, firms will have a lot of unsold goods. In this climate, they will cut back on investment.
Animal spirits. If there is an initial fall in investment, businessmen may have negative confidence. Their ‘animal spirits fear recession and lower profits, so they cut back on investment. Consumer confidence may be adversely affected, and they spend less too. Thus Keynes emphasised the importance of expectations and confidence.
Negative multiplier effect. Keynes popularised the idea of a multiplier effect. The idea that a fall in injections into the economy has a knock-on effect and the final impact may be greater than the initial. If a firm reduces investment, people lose their jobs, and this higher unemployment leads to lower spending and affects everyone in the economy.

UK saving-ratio-since-97 — Note: the surge in savings ratio at the start of 2008 recession.

A paradox of thrift. In a recession, people take a rational approach to be risk-averse – fearing a possible recession, they increase savings and spend less. When this lower spending is aggregated, it leads to lower overall demand in the economy.
Lower interest rates may not increase consumption very much because – the income effect of lower interest rates mean people have less income.

2. Sticky wages

According to classical economic theory, labour markets should clear. In this model, any unemployment is due to wages being artificially kept above the equilibrium through minimum wages e.t.c. (real wage unemployment) According to classical theory, the solution to unemployment is to cut wages and allow wages to clear. However, Keynes argued this was unsatisfactory.

Firstly, even in the absence of unions and minimum wages, workers would resist nominal wage cuts.
Secondly, a cut in wages wouldn’t necessarily solve disequilibrium. Lower wages would further depress income and spending, leading to lower aggregate demand, and therefore lower demand for labour.

Keynes’ contribution was to show the interaction between labour markets and the national economy, and not treat the labour market in isolation (e.g. from micro perspective). It is this macro perspective on savings and labour markets that led to the creation of macroeconomics.

Keynes theory on impact of falling wages was to a large extent supported by Irving Fisher in his Debt-Deflation Theory of Great Depressions (1933)

3. Importance of Aggregate Demand (AD)

An important classical assumption of the day was Say’s law. This stated that supply creates demand. However, Keynes believed the opposite was true. Keynes argued – demand determines the level of national output.

Policy implications of Keynesianism

1. Governments should provide counter-cyclical demand management.

Keynes was critical of the UK 1931 budget, which cut wages for hospital workers, and cut back spending on roads and new houses. He argued this would depress demand further and make the recession worse. Instead, he advocated higher government spending financed by higher borrowing.