Karl Marx - The Revolutionary Economist

There are few economists who have become both so reviled, and admired as Marx. Indeed some would even question whether Marx deserves to be called an economist; others would prefer terms like 'bungling and failed revolutionary'. However, there are certainly few economists who read so widely and wrote so much as Marx. Whether you love or loathe Marx, we cannot deny his writings had profound influence on the twentieth century.

What Did Marx Believe?

Marx believed society was an evolving struggle. He believed Capitalism was an evolving structure. However, unlike Adam Smith, Marx did not believe this evolution was always smooth, nor did he believe it evolved for the best. In fact Marx, predicted the collapse of Capitalism.

Marx placed great value on economic forces for explaining social structures. He argued that institutions such as church, education and the state evolved to support the capitalist class. But, Marx, was revolutionary in placing so much emphasis on the power of economic forces to influence society.

Marxist Critique of Capitalism.

Marx examined society and argued that the wealth of capitalists was based on paying labour less than their true labour value (underpaid labour). This difference between the true labour value and the wages paid led to the accumulation of money capital.

Marx argued that Capitalism was inherently unstable because:

• Workers were abused and disenfranchised. As capitalism developed, Marx predicted, workers would become increasingly alienated and seek to overthrow the capitalist class.
• Capitalists could make bad decisions about what to produce
• Growth was not guaranteed but could become volatile leading to periods of economic slump. Marxists certainly point to the Great Depression of a vindication of how capitalism can fail.

Failings of Marxism

The proletariat mostly became better off. Economic growth did enable Capitalists to make more profit, but, ultimately, workers benefited from real wage rises. In the nineteenth and twentieth century, labour was often exploited with poor conditions and low wages. But, workers have become better off. After all, it is in the interests of Capitalists to have a workforce who can afford to buy their goods.

The elusive 'dictatorship of the Proletariat' in practice tended to be more about 'dictatorship' and less about the proletariat. In some ways Marx was a democrat. He was criticising a system which did not extend the vote to large sways of the working class; he wanted these disenfranchised workers to be enfranchised. But, in practise, Marxism is indelibly linked to the totalitarian state of the Soviet Union.

Why Mention Marxism - Surely it is all History?

I can imagine some readers (especially in America) thinking why even mention Marx? Surely, he was hopelessly flawed and the inspiration behind the despotic Stalinist regime? It is worth mentioning what John Maynard Keynes says on Marxism (1931)

"How can I accept the [Communist] doctrine, which sets up as its bible, above and beyond criticism, an obsolete textbook which I know not only to be scientifically erroneous but without interest or application to the modern world? How can I adopt a creed which, preferring the mud to the fish, exalts the boorish proletariat above the bourgeoisie and the intelligentsia, who with all their faults, are the quality of life and surely carry the seeds of all human achievement? Even if we need a religion, how can we find it in the turbid rubbish of the red bookshop? It is hard for an educated, decent, intelligent son of Western Europe to find his ideals here, unless he has first suffered some strange and horrid process of conversion which has changed all his values."[13]

Why Marx is Important

• Marx was a revolutionary, he enabled a powerful critique of capitalism. This was perhaps essential for more informed criticism to emerge over time. We do not have to agree with a revolutionary to acknowledge that they bring new issues into a different perspective. I do not agree with Plato, but, at the time his work was important for the development for Western thought.
• Marx never lived to see the Russian Revolution. I imagine he would have generally supported Lenin and Trotsky, but would have been disgusted with Stalin who was only a Communist out of convenience to achieve his goal of absolute power.
• Whether we like it or not, the ideals of the Communist Manifesto did inspire many. At a time of vast inequality and widespread poverty, it is hardly surprising that many were excited by a vision of a society based on equality and fairness rather than the abject poverty and inequality prevalent in nineteenth century society.

Others in Great Economists Series

• Part 1 John Maynard Keynes


• Karl Marx Biography

Car Parking Charges - Why We should Pay More

The High Cost of Free Parking by Donald C. Shoup is an excellent investigation into the problems of parking in city centres.

The old saying is that "there is no such thing as a free meal", the same can be said for free parking.

Most city centres have limited space for parking, yet there is a reluctance by social authorities to charge the social cost of parking.
Because the price of parking is free (or very low), demand is greater than supply which results in highly inefficient waiting for available spaces.

On a recent visit to New York, we spent 20 minutes driving around several blocks looking for a car parking space. My driver said this was quite common, he also reckoned 25% of the traffic on the street was cars driving around looking for an empty space. When we finally found a space, the spot was of course free. But, in parking, we had actually faced several hidden costs.

• Time wasted - Time is Money. If you earn $30 an hour. 20 minutes is alot of money
• Cost of Gas.
• Frustration and uncertainty of ever finding a parking place
• Next time we may go to an inferior restaurant - at least we can get parking there. People worry that charging for parking leads to lower business. However, what they forget is that the difficulty in getting parking also puts people off.

However, it gets worse there are also additional social costs:

• Increased pollution from driving around the block.
• Increased congestion of people driving around looking for parking spaces.

With these social costs of parking, there is a good case for charging a significant price for parking. The money raised could be used to provide alternative public transport networks / park and ride. Alternatively the money raised from parking charges could lead to other taxes being reduced.

The problem is that people have an aversion to any new taxes or charges. But, if parking was better regulated through charging a realistic price they would actually benefit from greater social efficiency. It would mean those who really wanted to drive and park near the restaurant would be able to. A certain % would be discouraged from travelling to city centres by car, they could find alternative methods of transport; this would solve the problem of traffic jams as people look for available spots.

Free Trade Policy and Paradox

Free trade is one issue that seems to create a diverse polarity of views. There is a powerful political movement which decries the injustice of free trade. In many people's eyes, free trade has become synonymous with inequality and exploitation of the West over East. Whilst on the other hand, economists speak passionately about the benefits of free trade as the best tool to overcome global poverty. Who is correct?

Protectionism hurts the Developing World more than anything.

One striking issue is how opponents of free trade seem to ignore the damage of tariff protection on poor countries. The developed world have an unhealthy amount of subsidies on their declining agricultural sectors. The EU, has had massive external tariffs on food imports. The US also subsidise agriculture more than any other industry. The effect of these tariffs is to harm developing countries, especially food exporters.

EU tariffs mean that developing countries cannot export their products to the EU. If there really was free trade in agriculture, it is developing countries who would benefit the most. They would have more opportunities to export their agricultural exports. True, a few European farmers would lose out on artificially high prices. But, if you want to help reduce poverty amongst developing world farmers, it is free trade which will help the most. Agricultural subsidies and tariffs in the EU and the US have done more to harm poor farmers than free trade ever could. If campaigners for the developing world put their efforts into overcoming the powerful and selfish agricultural lobby, they would achieve some real benefits. As it is, by generating an instinctive mistrust of anything to do with free trade and globalisation, they create an impression of being ignorant political ideologues, unable to assess issues impartially on economic merits.

Does This Mean Free Trade is Always Good?

Just because free trade is usually beneficial and a powerful source of global growth, it doesn't mean that Free trade is always the answer for every country in every circumstance.

Developing countries may benefit from tariff protection to diversify their economy. If a country earns 80% of its export revenue through exporting raw materials, this does not reflect a balanced economy. It makes sense to try and diversify, even if current comparative advantage only lies with commodities. To diversify, tariff protection may be necessary, at least in short term.

There is a danger tariff protection may encourage inefficiency. But,

• Most developed countries had tariff protection during their development.
• Tariff protection should be short term and removed over time, like in many Asian economies.

This is where opponents of free trade may have a point. There is a justification for developing countries to have some tariff protection when developing new infant industries. To insist developing countries should always have free trade is hypocritical given than most developed countries used tariffs in their development period.

We can't assume free trade always will improve economic welfare for every country. But,generally speaking, developing countries will benefit most from the removal of tariff barriers, not the addition of more.

• Arguments against free trade
• Benefits of free trade

John Maynard Keynes - Great Economists Series

Over the next few weeks I will be writing about some of the great economists. I will not be attempting to discuss every aspect of their work, but, will be looking at their major contributions to the world of Economics

John Maynard Keynes makes a good starting point because he was both an influential economist and a man of many talents.

Unlike many economists, Keynes, was very much at home in the business world. He put his money where his mouth was and become a very successful financial speculator. It is said that his morning would begin by scanning the newspaper, from which he would make various investment decisions on the foreign exchange markets; often making a fortune from an hour's work. However, he did fail to predict the Stock Market crash of 1929; he lost a fortune, which he later recouped.

After studying at Eton and Kings College Cambridge, he received a lectureship to teach at Cambridge. This was personally funded by his old teacher Alfred Marshall (Marshall was himself a formidable economist). This lectureship and patronage of Marshall helped Keynes establish his reputation as an economist. During the First World War, Keynes worked in the Treasury office running the UK's foreign exchange operations. On one occasion he bought a lot of Spanish Pesetas, only to declare he would soon sell them and break the market - something he succeeded in doing.

Keynes and Versailles Peace Treaty

After the war, Keynes was part of the British delegation to the Versailles Peace Treaty. During the complex negotiations, he found time to pick up some French masterpieces including a Cezanne, at knock down prices. However, it was Versailles, which helped establish his reputation as an outstanding economist. Keynes became increasingly dismayed and alarmed at the vengeful and excessive terms of the treaty. Eventually, he resigned writing a polemic, criticising the Treaty as a recipe for future German resentment. The Economic Consequences of the Peace proved remarkably prophetic and helped establish his reputation as an independent thinker who could see beyond the orthodoxy of the day. Speaking on Georges Clemenceau the French PM, he didn't mince his words

“He had one illusion — France; and one disillusion — mankind, including Frenchmen.”

30 years later, Keynes, found himself as part of the British delegation securing another post war economic settlement; however, this settlement was to be of a very different nature. He was one of the architects of the Bretton Woods system, until his untimely death in April 1946 brought a premature end to his involvement.

Keynes was not just a brilliant economist and mathematician but also a lover of the arts, and music. He was a key member of the Bloomsbury social group based around Cambridge and London. He loved ballet and married a famous Russian ballerina Lydia Lopokova. He could exercise both kindness and a brilliantly sharp wit. On the return from one visit from Washington, a reporter asked him if England had just been sold out and become another American state. Keynes' succinct reply was . 'No such luck'

see more quotes by John Maynard Keynes

Keynes and Great Depression

It was during the 1930s, that Keynes' really made his mark as an economist, helping to develop a whole new branch of Economics.

When the Great Depression hit, with unprecedented ferocity, economists were at a loss to explain its causes and how to overcome it. Prevailing economic orthodoxy stuck to the old classical view that Markets will clear in the long run. At the height of the crisis, the fledgling Labour government was told by Treasury officials that the government must balance the budget to survive the depression. This effectively meant increasing taxes and cutting unemployment benefits. Keynes described this as economic madness and argued for the exact opposite. He argued in a recession of this magnitude, it was necessary for the government to intervene and actively stimulate the economy. Apart from a few half hearted attempts such as the new deal, Keynes' policies were largely ignored in the UK and US; and high levels of unemployment persisted until the start of the second world war.

It was to this backdrop that Keynes wrote his General Theory of Employment, Interest, and Money (1936). Quite a dense work, it still broke the mould of classical economics and created a powerful argument for active demand management. ALthough, his theories were later criticised by Monetarists, much of his thought remain key elements of modern economic theory.

Keynes was a great publicist for his theories. He would say things like:

"The government should pay people to dig holes in the ground and then fill them up."
People would reply. "that's stupid, why not pay people to build roads and schools"
Keynes would respond saying "Fine, pay them to build schools. The point is it doesn't matter what they do as long as the government is creating jobs". He wanted to emphasise the importance of intervening in a recession. Keynes was a new style of Economist. He wasn't just content to spend hours reading away in the British Library (like Karl Marx) he understood the importance of the soundbite and actually influencing the political process.

Quotes on Keynes

"No one in our age was cleverer than Keynes nor made less attempt to conceal it."

- R. F. Harrod in The Life of John Maynard Keynes (1951)

"We're all Keynesians now."

- US President Richard Nixon (1972)

"If you put two economists in a room, you get two opinions, unless one of them is Lord Keynes, in which case you get three opinions."

- Winston Churchill

• Keynesianism vs Monetarism
• John M.Keynes at wikipedia
• Keynes paradox of thrift
• Essay on dismal science
• Quotes by Keynes
  

Economic Forecasts

"While local economies may experience significant price imbalances, a national severe price distortion seems most unlikely in the United States, given its size and diversity."

Alan Greenspan, October 2004, playing down the threat of a national housing bubble.

Economic forecasts is certainly more of an art than a science. Put 10 economists in a room and the joke goes, you will get 11 different answers; that's certainly true for forecasting. Economists often have difficulty calculating existing statistics, let alone predicting future economic variables. For example, examining current account deficits suggest that the World has a current account deficit with itself. As we have not yet started trading with other planets, this must reflect statistical inaccuracies. When it comes to making forecasts, economists are even more likely to be wrong; but, just because some economic forecasts are wrong, doesn't mean we should ignore this branch of economics. It just means trying to make a better job of it.

What Determines the Success of Economic Forecasts?

• Current Data. Firstly, it is important to be aware of the correct current data. If we cannot be aware of how the economy is doing at the moment, it is very difficult to determine future trends. One difficult factor in predicting oil prices is that statistics on current oil stocks are hard to ascertain. For example, Saudi Arabia does not publish a full picture of its available reserves. There is much debate about the real rate of inflation see:
• Looking at All Variables. It is easy for people to look at only one aspect of an issue and come to a certain conclusion based on that. For example, in 2006, the ratio of mortgage payments to income was relatively low, compared to historical trends. This meant many felt house prices were not overvalued and due to fall. However, looking at house prices to earnings painted a different picture. House price to earnings had reached an all time high making it difficult for people to afford to purchase a house; when interest rates increased, the whole picture quickly changed.

• Understanding how Quickly Things Can Change. The problem with making economic forecasts is assuming that some variables will stay put. For example, the ratio of mortgage payments to income in the years 2004-06 was low, however, this was helped by record low interest rates. As soon as interest rates increased this cause the situation to change and mortgage payments rose changing the situation of the US Housing market.
• The Unexpected. This is the difficult thing to include in the equation. For example, oil price rises are notoriously difficult to predict, especially when sparked by political issues. The continued rise in oil has definitely led to higher inflation than most people would have predicted 12 months ago.
• Hidden Statistics. Banks and financial institutions are adept at hiding the true extent of their assets and liabilities. For example, the credit crunch took some by surprise because many were simply not aware of the risks that many subprime mortgage companies had exposed themselves to. Nor were most people aware of how mortgage debt had been sold around the global financial system. There are more than one examples, of companies who share price collapses as investors suddenly realise the true balance sheet.
• Hysteresis. It is often said, that if you listen to the predictions of top economists, you would actually get a more accurate forecast by just using last years statistic. For example, if inflation was 3% last year; there's a good chance it will be close to 3% again. Of course, economic statistics change from year to year; however, it is argued that using last years figure is often more accurate than choosing a forecast from others.

Economic Fundamentals Do Influence Forecasts. Despite all the difficulties careful analysis of economic fundamentals can help create good forecasts. If you look at the American economy a few years ago. There were many factors putting a downward pressure on the dollar

• Large current account deficit. 6.7% of GDP
• High levels of personal debt
• Low interest rates
• Growing uncertainty with economy.

All these made it easier to predict the dollar was likely to fall.

Keynesian vs Monetarist Theories

One of my readers wrote to me saying he enjoyed the site, but, couldn't help notice the influence of Keynesianism on my essays.

In a way he is right, in many essays I tend to be sympathetic towards a Keynesian / interventionist viewpoint. When teaching A Level economics we discuss different models of the economy. In particular we show the Keyensian vs Monetarist view of the Long Run Aggregate Supply. This is very simplified view

Keynesian view of Long Run Aggregate Supply

The Keynesian view is that output can be below full capacity for a long time. In a recession, labour markets don't clear and we are left with demand deficient unemployment. Keynes' general theory of money was written in the 1930s, when there was ample evidence of the failing of the free market to achieve full employment. Faced with this mass unemployment, Keynes advocated government intervention (higher government spending) to stimulate a depressed economy.

Monetarist View of Long Run Aggregate Supply

The monetarist view is a development of the classical theory. To simplify the model, Monetarists believe the Long Run Aggregate Supply Curve is inelastic. If AD rises faster than long run aggregate supply, there may be a temporary rise in real output, but, in the long run, output will return to the previous level of Real GDP. The impact of this theory is that government attempts to influence Real GDP through fiscal policy are at best ineffectual. This is because Expansionary fiscal policy only causes inflation. Classical economists argue that the economy will return to full employment, presuming that obstacles to the free working of markets are removed. inflationary pressures.

Sometimes when teaching a student will ask me - Are you a Keynesian Sir?

I am reluctant to say yes, because I feel that a good economist should not be tied to a particular ideological viewpoint. A good economist should always be flexible, ready to criticise his own belief's if evidence points in other directions.

However, broadly speaking, I do believe that governments or Central Banks should attempt to stabilise the economy through monetary and fiscal policy. They should not aim to avoid every cyclical fluctuation. But, intelligent monetary and fiscal policy can avoid the worst excesses of boom and bust. In a recession, fiscal policy can play a role in shortening the duration and intensity of the recession.

Related essays:

• Discuss whether demand side policies will reduce unemployment
• Outline problems of recovering from recession

Economics, Dogma and Ideology

My recent essay on Keynesianism vs Monetarism raised the issue of ideological beliefs amongst economists. It is hard to avoid associating yourself with a particular school of economics or certain ideology. But, if we become too attached to a set of beliefs it can cloud our judgement. What happens is we start to look for evidence to support our preconceived ideas, rather than looking at evidence and deciding what they point to.

For example, if we take an issue such as privatisation, people may have a preference either supportive or critical. But, the truth is the desirability of privatisation isn't so clear cut. In the UK, the privatisation of industries such as telecoms, electricity and gas were relatively successful (although some are still critical). There was an increase in efficiency, and in some industries there were lower prices. However, just because privatisation can increase efficiency in certain UK industries doesn't mean privatisation is always desirable. The last privatisation policy was for British Rail. This was a more difficult industry to privatise because:

• Railways are a natural monopoly making competition very difficult. Privatisation effectively creates a private monopoly.
  
• Railways are a loss making industry, but with positive externalities for society. (less congestion e.t.c) Therefore, a socially efficient outcome requires government subsidy and not market forces.
  
• The success of privatisation often depends on the regulatory framework which is implemented. Most UK industries privatised struggled to increase competition, therefore, the government needed a regulatory framework to avoid abuse of private monopolies. Ironically, the success of privatisation often depends on the regulatory framework set up by the government.
  

There are undoubtedly theoretical benefits of privatisation, and the IMF often want developing countries to undertake a policy of privatisation. However, exporting privatisation is not so as simple. It depends on the industries privatised, it depends how privatisation is managed, is there sufficient regulatory framework for the creation of private monopolies?

Ideology of Government Intervention

Another divisive issue is the extent of government intervention. Some will say government's are always inefficient and there should be minimal government spending. Others may feel government intervention is the solution to most problems. But, to make a sweeping judgement that government intervention is always inefficient, is as foolhardy as to say that government intervention always improves economic welfare. The desirability of government intervention depends on many factors:

• What area is the government spending. Is it an industry with positive externalities underconsumed in a free market?
• Is it a public good not provided in the free market.
• How effectively are the government bodies monitored for quality and efficiency of spending?
• What are the levels of corruption in society?
• Is the government spending subject to any discipline of the market?
• Is the spending targeted at worthwhile areas or due to political pressure of powerful lobby groups? EU spending on the Common Agricultural Policy was a triumph of political pressures over economic common sense. But, that doesn't mean agricultural subsidies have to always lead to inefficiency.

One of the great challenges for economics is to move political debates on from gross oversimplifications and ideological disputes. Issues cannot be solved with a blanket ideology of government's are bad, government's are good.

Review of the Economist Magazine

The Economist is one of the world's most respected publications, founded in September 1843. It is edited in London, but aims at being a global magazine. Half of its 1.3 million copies per issue are sold in North America. It is owned 50% by the Financial Times (a sub division of Pearson PLC) and 50% by private shareholders including members of the Rothschild Family.

It is not focused just on economics, but, examines issues relevant to current affairs. It claims

"to take part in a severe contest between intelligence, which presses forward, and an unworthy, timid ignorance obstructing our progress."

The Economist has certainly cultivated a reputation for being a thought provoking and informed read; but does it deserve this reputation?

Positive Aspects of The Economist

• The writing style is good, concise and sharp. The economist largely avoids the sentimentality and populism of the mass media. I wish my students would read it, just to improve their vocabulary and writing style.
  
• It has A Sense of Humour. (e.g. sending Freakonomics author Stephen Dubner a Pasty through the post) It's not exactly comic book stuff, but some remarks are at least witty; helping to make topics like financial derivatives a little less dull.
  
• They can admit they get things wrong. For example, although they initially supported the invasion of Iraq, they have since admitted that the invasion was deeply flawed. At least, this shows a little humility mostly lacking in politicians.
• Economic Perspective. I generally support their rationale for carbon taxes and road pricing - based on the externalities ignored by the free market. This shows they are not dogmatically pro-market as some may believe. As they are not running for election, they give the impression of evaluating topics on grounds of social efficiency rather than appealing to populist opinions.
  
• Social liberalism. E.g. Support for abolition of death penalty
• Not Complete Ideologues. Although the Economist could be described as socially liberal and fiscally conservative.
• Give Corrupt Politicians a hard time. The Economist rarely shirks from giving corrupt politicians and regimes a hard time.
• Forecasting is Not Bad. Although they get things wrong - like predicting cheap oil for the foreseeable future in 1999. They have been able identify some bubbles such as the internet dot com bubble in 1999 and the global housing bubble in the 2000s.
• Useful Statistics. I often use the statistics and country briefings for essays and teaching purposes. Their Big Mac Index has made it into textbooks as a useful introduction to ideas of PPP
• Compared to some of their Rival Newspapers / Media, The Economist seems a model of journalistic integrity.
  

Negative Aspects of The Economist

• It gets a little tiresome the way that they feel nearly any economic problem can be solved through 'privatisation, deregulation and more flexible labour markets.'
• Their judgement is often sadly lacking. E.g. Supporting Bush in 2000, and supporting the invasion or Iraq. If it had been any magazine, I would have cancelled my subscription; but, because the Economist has a high quality of journalism I bit the bullet and continued to subscribe. At least they don't waste time trying to justify their decision in the face of contrary evidence.
• All articles conform to the same editorial mode, suggesting writers have to start from a certain viewpoint; this creates less scope for journalistic independence.

Overall

As an economics teacher, the economist is an invaluable resource. It reflects a certain ideology and you certainly wouldn't want it to be your only reading material. But, as a simplified guide to global problems and issues, there are few better starting points than the Economist.

• The Economist
• The Economist at Wikipedia

The Economist in The Simpsons

In The Simpsons episode "Catch 'Em If You Can", Homer is traveling by air in first class and says "Look at me, I'm reading The Economist. Did you know Indonesia is at a crossroads?" and when questioned by his wife, he simply replies "It is!" Four days later, with its customary dry wit, The Economist alluded to the quote, and published an article about Indonesia referring to the "crossroads". The title of the issue was "Indonesia's Gambit".

What Do You Think of the Economist?

10,000,000 Dollars - Highest Note Value

A 10 million Dollar note - but are there any goods to buy?

Zimbabwe's beleaguered economy posted a record inflation rate last month. The Central Bank's governor stated inflation in Zimbabwe has now reached 2.2million % - a thirteen fold increase in inflation since February.

Hyperinflation seems out of control as the economy collapses on the back of disruption to supply and unworkable price controls. Life expectancy in Zimbabwe is one of the lowest in the world; it is only 34 for women. 3 million have fled to neighbouring countries.

Costs of Hyperinflation Include:

- Menu costs - costs of changing price lists
- Collapse in economic confidence
- Sheer difficulty in dealing with prices rising at astronomical levels
- Hyperinflation is often symptomatic of underlying problems in economy
- Savings flee economy

• Hyperinflation - Causes, Costs and examples
• Hyperinflation in Zimbabwe
• Zimbabwe inflation soars at Guardian
• UK Inflation increases to 3.8%
  

Bailing Out The Banking Sector and Moral Hazard

A common concept in economics is the idea of moral hazard. Basically, this states that a decision can influence future behaviour - often for the worse.

Suppose you have a child who gets into debt. If you unconditionally bail him out and pay off his debts, he may think "great. I can spend whatever I like, as I know my parents will bail me out!" So, in the future, he just gets into a bigger debt . This is moral hazard. At first glance it seems sense to pay off his credit card debt and avoid paying interest payments at 17%; this saves the family money in the future. However, by paying off his debt, it encourages bad economic decisions. This is why a parent would be reluctant to pay off a child's debts without making them commit to changing their behaviour.

• Suppose a bank makes a series of bad loans to people with poor credit histories. Maybe they sell mortgages to people who have no chance of paying them back. (sound familiar?)
• In a few years time, the borrowers unexpectedly start to default on their debt. The bank starts to lose money and could be threatened with bankruptcy.
• The problem is that if a bank goes bankrupt it would seriously undermine the whole financial sector. If people see one bank go under they may start withdrawing their money from all banks. This could cause a financial meltdown. In 2007, the UK experienced this panic as investors rushed to withdraw savings from Northern Rock. In the 1930s, lack of confidence in the banking sector caused people to withdraw their savings and many small and medium sized banks went bankrupt.

So the Government and Federal Reserve have a dilemma. If they do nothing, they risk financial meltdown in the banking sector. However, if they intervene and save the bank, they are in a way saving a bank from it's own bad decisions. Furthermore, it risks moral hazard. If banks know they will always get bailed out they can worry less about making bad loans. If things go pear shaped again the government will always bail them out.

Arguably, the way the government responded to the dotcom bubble of 2000 created moral hazard. The dot com boom and bust caused a risk of a recession as share prices plummeted. Therefore, the Fed cut interest rates very aggressively, close to 1%. This helped avoid a deep recession in 2000-01, but, it created a climate of lax lending in the period 2002-06 and another boom and bust, this time in the mortgage sector. The financial authorities overcome one problem only to create a bigger one in the future.

What is the Solution?

One solution is to bail out the banks and prevent immediate short term problems. But, then the government and / or financial regulators have a responsibility to regulate the banking sector to make sure bad loans are not repeated. Of course, this is easier said than done; but, these issues of moral hazard present a real dilemma for Monetary authorities - To risk financial meltdown or 'reward' bad behaviour.

What do you think? Should the government be bailing out banks who make bad decisions?

How Much Does It Cost To Post A Letter?

Royal Mail used to have a simple system for costing letters. A letter was either first class 36p or second class 27p. However, the Royal Mail felt this was an inefficient method of paying for postage. because the cost of delivery depends on:

• How much it weighs
• How big the letter is.
• How Far it has to travel

Therefore, they introduced a new pricing strategy, which charged different prices for size of letter (small letter - big letter, package) and also introduced more weight bands.

From an economic point of view this is more efficient. It makes it easier to charge the consumer the marginal cost of delivering the letter. It should encourage some to use smaller letters and reduce unnecessary weight. Previously, there was no incentive. In theory, this more efficient pricing should help reduce costs and lower the overall price of letters.

The Problem of Complicated Pricing

The problem with this new range of pricing structures is that it becomes more difficult to know how much a letter is going to cost. It results in people, either wasting time in measuring / weighing letters or people spending too much money on postage.

In the past few months, I have been uncertain about the weight and size of big letters, rather than

• Waste time going to the post office to have it weighed
• Buy a weighing scales.

I've just put 2 or 3 stamps on and hoped for the best.

This is because I'm always thinking of the opportunity cost. I'd rather spend and extra 36p on a 2nd stamp I don't really need, rather than waste time searching the proper price. The packages are important so I can't risk them not getting there, so I just put on enough stamps to make sure there is no risk. Therefore, I'm sure I've paid more in stamps than I should have done. But, as an infrequent poster, it makes sense to lose a couple of pounds rather than invest time in working out the correct price.
If you can earn £20 an hour, why spend even 5 minutes on measuring and weighing a letter so you can save 37p?

For me, the pricing change is not good. I've lost out, but, paying too much for postage is better than the alternative - wasting time in working out whether to pay 37p, 44p or 66p e.t.c.

It just shows, in the real world, ideas of allocative efficiency are more difficult to work than theory suggests.

By the way, researching this post, I found two useful pages, which will make it easier in the future to know the correct postage. The time investment was about 15 minutes, so it will eventually pay me back. But, if I hadn't been writing this post, I would never have bothered.

Pages on cost of Posting in UK

• Postage rates UK
• Weight Comparison Guide

Is Inflation Under of Overestimated?

Readers Comment: "Have you read the book Your money or your life? It talks about how you only incur inflation on certain things while other things actually deflate over time (technology like computers and televisions and phones, etc), so when predicting for your own personal future, inflation is overrated. I'm curious what your thoughts are on this.

It's a good question, I haven't read the book, but, I would like to mention a few points on measuring inflation. We tend to assume that the official rate of inflation must be correct, but, actually there is a lot of debate about the calculation of inflation. It is also interesting you mention that inflation is overestimated, many suggest inflation is underestimated.

Hedonics and Inflation

In the US, the BLS, used hedonics to calculate inflation. What this means is that they take into account changes in product quality.For example, the top of the range quality computer may increase in price from $700 to $750. (e.g. top of the range Apple Macs seem to get a little more expensive, but with much better features) But, because the new computer is twice as powerfu, the BLS works out that the price of computers has fallen, even though the top of the range computers may be getting a little more expensive. Maybe the same thing happens with cars; Ford bring out the latest model, which is 10% more expensive, but has '20%' better features - GPS, airbags, impact protection e.t.c. In theory, this is 10% fall in the 'price' (Note, these are just theoretical examples to explain how hedonics could be implementd)

The problem is judging the quality of a product is very much a normative opinion. The latest mobile phone may have many more features, but how many people actually use them? It is the same with computers; a new computer may be twice as fast, but, how much does it actually increase the user experience? - I would argue much less than the manufacturers would like to admit.

Therefore, you could argue that if the BLS overestimates product improvements, the inflation rate is underestimated.

On the other hand, there are many products which actually may deteriorate in value. E.g. Food may be cheaper than 50 years ago, but, more chemicals are used in the process and many argue vegetables taste more bland. It's the same with many goods which are no longer built to last. Therefore, if goods are becoming worse quality, maybe inflation is underestimated. interesting thread here Big Picture - Hedonics

The truth is that you could make arguments both ways, but, it is illustrative of how difficult it is to measure inflation exactly. BTW, I haven't completely answered your question, I will try come back to it later.

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How Damaging Are Recessions?

Sometimes the media give the impression that a recession will lead to widespread economic disaster. It is easy to drag up memories of the Great Depression, the Jarrow Crusade, and unemployment rates of 30% +. This is made easier because the media highlight the bad news; the companies who go bankrupt, the people who are made unemployed, falling house prices.

Negative news makes the most interesting headlines; the media won't start reporting - "Big supermarkets doing OK - no job losses this year" I don't blame them for this, however, it is worth bearing in mind that for most people a recession might not actually change things very much. Most people will keep their jobs, most companies won't go bankrupt. For example, in the last recession, unemployment in the UK doubled from 1.5million (5%) to 3 million (10% of workforce). But, the majority of people still kept their jobs.

People are more likely to be directly affected by rising costs of living. The rise in food and energy prices is hard to ignore; it is estimated that many consumers could be worse off this year because prices are rising faster than wages. This is what people will notice. Interestingly, many non-economists may confuse the concepts of recession and inflation. However, it is worth pointing out that although rising oil prices may help to cause a recession. A recession means real output or at least real output per capita falls.

Of course, for those who are made unemployed in a recession, the effects are severe. Being made unemployed is one of the most stressful events in life, both economically and on an individual level. Surviving on unemployment benefits is no joke and the impact far greater than rising petrol prices

The impact of a recession also depends on various factors such as:

How Long does Recession Last? An important factor is how long and how deep the recession is. One of the notable features of the Great Depression was how long the mass unemployment existed. More recent recessions have been shorter in duration.

Some sectors hit more than others. The impact of a recession is not equally distributed throughout the economy. A recession will usually affect some sectors much more than others. For example, in the present downturn, it is the construction sector which is particularly badly hit. This is for two reasons:

• The collapse in house prices
• Construction investment tends to be more volatile than economic growth.

Some firms will be hit more than others. Early casualties of the current downturn are companies like Starbucks and Marks & Spencer. Both have businesses focused on luxury items. E.g. Starbucks coffee could be considered an expensive luxury; it is the kind of spending you can easily cut out. Other companies producing basic food items are barely touched by a recession. People do not stop buying grocery items in a recession; they just buy less luxury items like a takeaway Starbucks or Marks & Spencer organic salad.

The important thing is that some firms will be hit much harder than others. If you're not in construction, real estate or producing luxury SUV cars, the impact of the forthcoming recession may feel more muted.

Does Anyone Benefit from A Recession?

Some economists may even go as far as saying a recession can have a beneficial impact because it increases the long term efficiency of the economy. See: Does Anyone Benefit from a recession?
Can a Recession be A Good thing?

Are Recessions Inevitable?

This is a good question, I will look at this later. It is related to another question - Are recessions getting shorter?

The Effect of A Recession

There is a lot of talk about recession at the moment. There is a general understanding recessions are bad, but what does it actually mean to be in a recession and how does this affect the average consumer?

The definition of a recession is negative economic growth for two consecutive quarters. This means a fall in Real GDP, - lower National income and lower National Output. However, it is worth noting some people talk of a recession, even when growth is very low.

A recession is characterised by:

• Rising unemployment (often unemployment is a delayed factor) i.e. it takes time for unemployment to rise, but, even when the economy is recovering, it takes time for unemployment to fall.
• Rising Government Borrowing. A recession is bad news for the government budget. A recession leads to lower tax revenues (lower income tax and corporation tax revenues) and higher government spending on unemployment benefits. The UK is forecast to borrow £60 billion, a recession could make this borrowing even worse in 2009. This borrowing means higher taxes and higher interest payments in the future.
• Falling Share Prices. Generally a recession leads to lower profitability and lower dividends. Therefore, shares are less attractive. Note share prices often fall in anticipation of a recession. e.g. the recent falls in share prices are largely because the market expects a recession soon. During the actual recession, share prices often increase in anticipation of the economy recovering. Note also, falling share prices don't always mean a recession, falling share prices can occur for many other reasons.
• Lower Inflation. Typically a recession reduces demand and wage inflation. This should result in a lower inflation rate. However, this recession is complicated because of rising oil prices. Therefore, the forthcoming recession may actually occur simultaneously with higher inflation - a term known as stagflation. But, a recession will definitely reduce demand pull inflation pressures and encourages price wars on the high street as firms seek to retain consumers.
• Falling investment. Investment is much more volatile than economic growth. Even a slowdown in the growth rate (economy expanding at a slower rate) can lead to a significant fall in investment.

Related

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Renewable Energy or How I Learned To Love A World Without Oil

In Dr Strangelove or "How, I Learnt to stop worrying and Love the Bomb", we see the crazy potential of a nuclear war become a reality. Our economies have become so dependent on oil, it seems equally crazy that we could live without oil; thus rising oil prices spark an instinctive fear, especially amongst oil importers. However, a world without oil is not only possible, but, at some time an inevitability. Rather than fighting a losing battle, this is how we can learn to welcome a post-oil economy.

The Motor Car is Not everything.

The arrival of the motor car was welcomed with an unquestioning enthusiasm. It gave a new freedom to a whole generation of people. But, in the rush to accommodate the motor car, we have created an unbalanced transport system with many drawbacks

• Firstly, car accidents are one of the world's biggest killers. It is the most common killer of young men in the UK.
• It contributes to global warming which is causing severe environmental damage.
• Congestion blights most city centres leading to an inefficient allocation of resources. Average speed of travel in London (7mph) [link] this is as slow now as it was in the nineteenth century when we used the horse and cart. So much for progress...

Instead of the motor car, people are realising the benefits of cycling. Good health, less pollution, fun and often much quicker. See: Amsterdam at rush hour.

In the US, the rise in oil prices has come as a shock. For the first time higher prices are forcing many to consider public transport; this has equally been a shocking experience. The rise in demand for public transport has only highlighted how poor public transport is in the US; not surprising after years of underinvestment in favour of promoting the motor car.
Rather than rely on cars, we can make much greater use of public transport.

Energy can be provided by other means

There was a time we relied on the horse and cart, then came the steam engine. We did not run out of horses or coal, we just found better methods. There is no reason why we cannot find alternatives to petrol and oil. In fact, the alternatives are already there, they just need investment to help reduce their operating costs and make them as attractive as oil.

• Solar power
• Hydrogen energy
• Electricity from renewable resources such as wind, tidal energy.

At the moment, as the King of Saudi Arabia pointed out, renewable resources are still more expensive than oil. But, we should never underestimate the power of technology to reduce costs. The issue is that we shouldn't wait for market forces and oil companies to give it sufficient investment. This is one area where government intervention is justified to overcome the market failure of insufficient investment.

Reducing the Power of OPEC Countries is no Bad Thing

At the moment, most western economies are dependent on importing from OPEC countries primarily in the middle east. (Supplies in the US and UK, already show signs of decline) Rising oil prices only increase the economic and political leverage of oil exporting countries. The sooner we can reduce our dependency on oil importing countries the better. It will also help to redistribute income throughout the world.

Environment

We are learning, perhaps too late that consumption of oil creates carbon emissions which are causing a destabilising impact on the environment. Perhaps most pressing is the issue of global warming. The consequences cannot be brushed off, as some would like to do; there is increasing evidence that global warming is promoting rogue weather patterns which will cause tremendous harm. Switching to renewable energy will reduce the excess carbon emissions which are causing so many problems.

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Why Is Economics Called the Dismal Science?

Thanks to reader David Dyer, who pointed out this interesting article on the origins of economics being called the Dismal Science. 150 Years and still dismal

It appears that the term 'dismal science' was first coined by Thomas Carlyle, in December 1849, “Occasional Discourse on the Negro Question” in the London monthly Fraser’s Magazine.

In particular, Carlyle was criticising the economists belief in supply and demand which stood in sharp contrast to his idealised view of a slave society. Carlyle, like many of the Victorian age, considered blacks to be inferior to whites (he referred to blacks as ("two-legged cattle") and therefore these non whites needed the 'beneficient whip' to be useful to society. This view, he held, justified slavery as a model for society, and he criticised those economists and evangelists who believed in equality and freedom of the people. This view on equality was held by thinkers such as John Stuart Mill, Harriet Martineau and Charles Darwin. But, at the time many such as Carlyle, Dickens and Alfred Tennyson did not hold this belief.

Carlyle's view on Economics was

"quite abject and distressing...dismal science...led by sacred cause of Black Emancipation."

Thus in a nutshell, Carlyle dislike economics because of its support for black emancipation and the ending of slavery

Dismal Science and Malthus

Carlyle also was critical of T.Malthus, view on over population. In an essay on Chartism 1839, Carlyle wrote

"The controversies on Malthus and the 'Population Principle', 'Preventative Check' and so forth, with which the public ear has been deafened for a long while, are indeed sufficiently mournful. Dreary, stolid, dismal, without hope for this world or the next, is all that of the preventative check and the denial of the preventative check."

It is this that helped make a link between Economics and 'the Dismal Science'. But, it is worth remembering that in this quote he only referred to the 'dismal' prophecies. The origin of the term, 'dismal science' came about also because of the opposition of economists to slavery as a morally superior state of affairs.

Related

• Essay on the Dismal Science
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The Importance of Inflation Expectations

During the 1960s and 1970s, Milton Friedman helped change attitudes to Monetary policy and inflation with his theory of adaptive expectations. This model suggested that expectations of inflation played a crucial role in determining future inflation. A simple application states inflation expectations = last years inflation rate.

However, a limitation of the model was that it assumed that people's expectations were always based on the past, leaving no room for future trends. In practice, people's expectations of inflation is far more complex than simply looking at the past. This led to the development of rational expectations, which stated people would rationally be able to predict future inflation based on numerous variables.

• For example, if consumers saw an excessive loosening of monetary policy, they would know that this would not increase real GDP, but just cause inflationary pressure to build; therefore, inflationary expectations would change immediately and not wait for the inflation to occur.
  

Of course, this rational expectation model places great faith in the economic reasoning of the average consumer. If my economic students don't grasp the inflationary impact of expansionary monetary policy, I'm not sure we can expect Tom, Dick and Harry on the street to correctly forecast inflation on the grounds of excessive growth in the money supply.

Nevertheless, inflation expectations are very important and in the long term the attitude and success of the Central Bank is important for influencing inflation expectations.

What Determines Inflation Expectations?

Current Inflation. This is undoubtedly important. Higher inflation does feed through into higher expectations. The several years of low inflation has helped to reduce inflation expectations; there is a danger that the current oil induced inflation spike could feed through into higher expectations and this could damage the good work done in the past decade.

Perceived Inflation. The problem is that consumers increasingly don't trust inflation statistics. For example, many in the UK, feel that their personal inflation rate is significantly higher than the official CPI index. We looked at reasons why this might be the case - see: Real inflation rate.

Cost Push or Demand Pull inflation. It is interesting that consumers inflationary expectations seem to be largely based on the price of important commodities. They place less emphasis on the economic cycle. Central bankers are hoping that the forthcoming slowdown in economic growth will reduce inflation expectations, but, it is not clear whether consumers make the link between slowing growth and lower inflation. I often notice people assume inflation and recessions go together.

Difference Between Nominal Bond Yields and Index Bond Yields. One gauge of measuring inflation is the difference between the yield on index linked bonds and ordinary nominal bonds. The theory is that if people expect inflation to rise, they will need a higher yield on nominal bonds to compensate for the threat of inflation. However, there are limitations of this method, as the market for index linked bonds is relatively small and other factors can affect bond yields as well as inflation expectations.

How Inflation Expectations Influence Inflation and Monetary Policy

If people expect low inflation, monetary policy is more effective. A quarter point rise may be sufficient to reduce inflation. If people have high inflationary expectations, the Central Bank may need to increase interest rates by a much bigger % to have a similar effect.

For example, in 1990, interest rates in the UK needed to rise to 12% to reduce the inflation of the Lawson boom. In the US, interest rates were 10%, when inflation was only 4%.

Central banks definitely have much benefit from keeping inflationary expectations low. The only problem is that reducing inflation with rising oil prices, could push the economy into recession; it is certainly a difficult dilemma.

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10 Reasons Not To Cut Petrol Tax

The Daily Express has a campaign, stop petrol tax robbery They are calling for a massive cut in petrol tax. Whilst this may be popular with motorists, does it make any economic sense to cut petrol taxes? These are 10 reasons why the Express is wrong and the government should persist with petrol taxes.

1. Congestion.

Congestion on UK roads costs the UK economy over £21 billion a year. Without petrol tax, the costs of congestion would be much worse. Higher petrol prices are forcing people to find alternative means of transport; it is giving the economy an unexpected boon of quieter roads, which leads to much greater efficiency and less time wasted in traffic jams

2. Pollution

Consumption of petrol causes CO2 emissions. High prices help to moderate demand and reduce pollution levels. This helps the UK meet its carbon emission targets; it also helps improve air quality in city centres.

3. More efficient driving

Higher petrol prices have encouraged people to drive more efficiently; people are driving slower. People are shopping locally rather than going to out of town supermarkets. In many ways, the higher oil prices are encouraging more efficient driving. See: Effect of higher petrol prices

4. More efficient Engines.

On the producers side, there is an increased incentive to develop more fuel efficient engines, rather than the gas guzzling SUVs.

5. Inequality

Often you hear an argument, higher petrol prices are not fair, because poor people cannot afford them. However, this is the wrong approach to reducing poverty. The role of petrol taxes is not to deal with relative poverty. The best way to reduce poverty is increase the incomes of the poor, not cut petrol taxes. Petrol taxes should be set at the socially efficient level; if the government is concerned about equity issues, it should adress them directly, not indirectly through altering indirect taxes on cigarrettes, petrol and alcohol.

6. Encourages Alternatives

Higher oil prices, encourages the development of alternative energy sources, such as electric cars, hydrogen powered cars. We need to find alternatives to oil; the sooner we do it, the smoother the transition will be.

7. Raises Revenue

If you cut petrol taxes, the government will have to simply raise other taxes. There is no welfare gain from cutting petrol taxes. It only changes the way taxes are collected. Whether we pay income tax or petrol tax it does not affect our living standards. If petrol tax has beneficial effects of increasing social efficiency, then we might as well pay tax this way rather than through more inefficient taxes such as income tax.

8. Rising Oil Prices are a signal we need to find alternatives.

You can't buck the market for ever. Oil is a non renewable energy source. The higher price of oil cannot be explained through speculation; prices are high because demand is rising faster than supply. To try subsidise lower oil prices is only to delay the necessary switch to other energy sources.

9. Petrol tax pays for the external cost of driving cars and lorries.

Driving cars and lorries create many negative externalties. Petrol tax helps covers these externalities. They include:

• Cost of repairing roads worn out (especially by lorries)
• Pollution costs
• Congestion costs
• Costs of accidents (over 3,000 deaths in UK alone). Less traffic will reduce this level of fatalities.

10. It is necessary to switch Transport Methods

There was a time when many people were employed driving horses and carts. Technological changes necessarily made these horse and cart drivers redundant. But, other jobs are created. If less goods are transported by lorry, it will create increased demand in other sectors of the economy such as trains.

There is a populist demand to cut petrol taxes, but, just because a tax cut is popular doesn't mean it is a good idea. To subsidise consumption of petrol at this point in time, would be the worst possible mistake. We need to develop an alternative to petrol, and the sooner the better. The effects of rising oil prices are actually very beneficial and future generations will welcome the changes that we are making now. To prolong the supremacy of cheap petrol prices would do nothing to help the environment, congestion and long term energy prospects of the economy.

Of course, politicians may not be swayed by economics, after all they have to get re-elected. But, that doesn't mean cutting taxes would be a good thing. Keep petrol prices high.

Related:

Why is price of oil rising?

How to deal with rising oil prices