A primer on collusion

Collusion exists when oligopolistic firms agree to fix prices and to engage in other anticompetitive behavior. The firms behave as if they were a monopoly setting price and aiming at maximizing joint profits. Collusion is illegal in the US and the EU and in many other countries so firms take extreme precautions to remain undetected. Such collusion is referred to as tacit collusion. If the collusive practices are revealed then the structure is referred to as a cartel. The term cartel also refers to the rare cases of explicit collusion such as OPEC or the De Beers 'family (!) of companies' (a favorite example of my dear friend MM).

This IHT article ('Oil companies carved up the market for paraffin in style') is a beauty in its description of cartel practices:

Surrounded by a moat and four watch towers, the ancient Château d'Ermenonville is not the kind of place anyone would associate with a product as mundane as paraffin.

But the château, a discreet luxury hotel about a 40-minute drive northeast of Paris, and a circuit of others around Europe served for more than a dozen years as bases for executives from some of the biggest names in oil - Exxon Mobil; Royal Dutch Shell; Sasol, of South Africa; and Repsol YPF, of Spain - to fix prices of paraffin, the overlooked wax byproduct of crude oil, that is used in candles, paper cups, lip balm and chewing gum.

(chewing gum????? ughhhh)

The scheme drove up prices to consumers in a plot that probably touched most every household, according to the European commissioner for competition, Neelie Kroes, whose office punished nine oil companies with more than half a billion euros in penalties.

Most cartels operate in secrecy, destroying documents, encrypting e-mail messages or using prepaid phone cards to erase communication traces. But the paraffin cartel was rare in that some members - notably Tibor Toth, a manager with the Hungarian oil company MOL - kept minutes, and attendance lists.

Cartel members e-mailed invitations and sought RSVPs. They booked each other's rooms and played host to open bars. Documents found when investigators first raided the companies in April 2005 included handwritten notes on stationery from hotels on the cartel's itinerary: the five-star Kempinski in Budapest or Château de Montvillargenne in the bucolic horse country of Chantilly, France.

"Next price increase May/June 2000," a Shell executive scribbled in a note after a meeting in Paris. Toth, writing in Hungarian, recorded new prices in West German marks, or Deutsche marks. "Raise in January unless first-quarter quantities are reduced, otherwise raise in season, DM 120."

The behavior of this group and its undoing pose significant concerns.

The relaxed clubiness of the paraffin conspirators stokes worries about the hold that price-fixing cartels have on European commerce.

With Kroes cracking down on cartels involving elevators, cement, automotive glass and drugs, total annual fines in the past five years have more than tripled, reaching €2.27 billion, or $3 billion, this year. The money goes into the EU general budget.

A couple of issues here. First that perhaps fines are not enough to stop such behavior. As long as the collusive practices remain undetected the executives reap the benefits of increased profits under their direction while if the scheme is revealed then it's the company that pays the fines. Perhaps the risk of being sent to prison works better...(Read on this the article 'Well-dressed thieves: Why the threat of prison is necessary to deter cartels' here and here).

Also:
We know that cartels are unstable structures because each menber has the incentive to cheat. A cartel structure is less likely to collapse if there are few members controlling most of the industry's output, if the good is homogeneous, if cost structures are similar, if demand is buoyant etc. We notice that cartels have been operating in the elevator, cement, automotive glass and drugs industries as well as marine hose industry (used to funnel oil from tankers to storage facilities), glass and cardboard industries etc. Most involve homogeneous products that are typically used as inputs by other firms. (but, read this for a counterexample). Also, we read in the article that:

...their nine companies controlled 75 percent of the European market

which is considered big enough to pull it off (but, OPEC now controls only 40%!)

Check out the full article to get a feeling of how collusion works outside textbooks.

PS for Greek students: read this article (in Greek) from Kathimerini on the cartel situation in Greece and on the threats and pressure that the members of the competition commission face from several companies......
(But I found this brief note in the English edition::

Competition watchdog wants backing from MPs in its probes

The president of Greece’s Competition Commission, Spyros Zisimopoulos, pleaded with Parliament yesterday for the country’s politicians to support his efforts to crackdown on improper market practices. Zisimopoulos informed deputies that the competition watchdog is investigating a number of sectors of the economy, including cosmetics, cement production and fertilizers. “The commission has opened up a lot of fronts where there are some powerful interests at stake,” he told MPs, as he alleged that some companies are trying to undermine the watchdog’s work. Zisimopoulos did not name any firms.)

Check out these trade barriers

'In Indonesia, the third most populous country in Asia after China and India, the government is already acting to limit imports of garments, electronics, shoes, toys and food — five large categories in which Indonesian producers are struggling to compete with China. Starting in the new year, importers of these products will have to be registered with the government, use only five designated ports for their shipments, arrange for a detailed inspection of goods before they are loaded on a ship or plane bound for Indonesia and then have every single container exhaustively inspected on arrival by Indonesia’s notoriously slow customs bureaucracy. The plan, intended to comply with W.T.O. rules, was adopted after heavy lobbying by Indonesian manufacturers and labor unions'

This was spotted here, a discussion of how much China's exports may slow down at this juncture.

I think our Poitiers example will (at last) be updated....

New 'kids' on the block

This one is for my (IB) kids planning to do economics later in college. It is a list of very young economists who, according to The Economist, seem most promising. Who are they?

Jesse Shapiro of the University of Chicago
Roland Fryer of Harvard
Esther Duflo of MIT
Amy Finkelstein of MIT
Raj Chetty of Harvard
Iván Werning of MIT
Xavier Gabaix of New York University
Marc Melitz of Princeton University

Well, VasH, make sure you sign up for Dr. Shapiro's courses!!

Concerning Ms. Esther Dufflo, I would like to quote the following, as (supposedly) you (Candidates 2009) are immersed in the study of development related issues:

Esther Duflo of the Massachusetts Institute of Technology (MIT) received more recommendations than any other economist. With her colleague, Abhijit Banerjee, Ms Duflo have remade development economics, nudging it away from its concern with policies, towards a preoccupation with projects.

They study economic development as seen from the field, clinic or school, rather than the finance ministry. They might be called the “peace corps” of economists, bringing the blessing of their investigative technique to the neglected villages of India or the denuded farms of western Kenya.

Ms Duflo has made her name carrying out randomised trials of development projects, such as fertiliser subsidies and school recruitment. In these trials, people are randomly assigned to a “treatment” group, which benefits from the project, and a “control” group, which does not. By comparing the average outcome of each group, she can establish whether the project worked and precisely how well.

In one study, Ms Duflo and her colleagues showed that mothers in the Indian state of Rajasthan are three times as likely to have their children vaccinated if they are rewarded with a kilogram of daal (lentils) at the immunisation camp. The result is useful to aid workers, but puzzling to economists: why should such a modest incentive (worth less than 50 cents) make such a big difference? Immunisation can save a child’s life; a bag of lentils should not sway the mother’s decision either way.

Randomised trials “give you the chance to be surprised”, Ms Duflo says. Had they arrived at this result using some other method, she and her colleagues would have assumed they had made a mistake. But randomisation removes such doubts, showing that it was indeed the lentils that made the difference. The result cannot be dismissed; it must be explained.

The approach has its critics. A randomised trial can prove that a remedy works, without necessarily showing why. It may not do much to illuminate the mechanism between the lever the experimenters pull and the results they measure. This makes it harder to predict how other people would respond to the remedy or how the same people would respond to an alternative. And even if the trial works on average, that does not mean it will work for any particular individual.

The randomistas, as Ms Duflo and her comrades are called, liken their studies to the clinical trials that prove the efficacy of new drugs. But the ultimate ambition of economics is for something more akin to anatomy. Researchers hope to dissect the underlying physiology of an economic problem, revealing how the leg bone is connected to the thigh bone. With a full anatomy of behaviour—what economists call a structural model—they can determine if a policy or project will work even before it has been attempted.

The early anatomists of the human body suffered from a shortage of fresh cadavers to work on. Medical students would trek long distances to watch a dissection performed. Economists often find themselves in a similar predicament. Short of good empirical meat, they have to rely on elaborate theory and guesswork to fill in what they cannot observe.

The full article can be found here and I would advise you to read it. I was made aware of it thanks to Levitt's (he had made the list!) blog, Freakonomics

Information and economics

Professor Lord Robert Skidelsky is at Warwick and is best known for his 3 volume biography of Keynes. We've referred to him before in a couple of older posts. This article is interesting not only because it presents the basic idea(s) behind asymmetric information, the Akerlof 'lemons' paper and adverse selection in simple terms but also on how it relates the issue of information or lack of it to the current crisis.

Although designed before the current crisis, these models seem to fit current observations rather well: banks lending to entrepreneurs who could never repay, and asset prices changing even if there were no changes in conditions.

But a moment’s thought will show why these models cannot explain today’s general crisis. They rely on someone getting the better of someone else: the better informed gain – at least in the short-term – at the expense of the worse informed. In fact, they are in the nature of swindles. So these models cannot explain a situation in which everyone, or almost everyone, is losing – or, for that matter, winning – at the same time.

The theorists of asymmetric information occupy a deviant branch of mainstream economics. They agree with the mainstream that there is perfect information available somewhere out there, including perfect knowledge about how the different parts of the economy fit together. They differ only in believing that not everyone possesses it. In Akerlof’s example, the problem with selling a used car at an efficient price is not that no one knows how likely it is to break down, but rather that the seller knows perfectly well how likely it is to break down, and the buyer does not.

And yet the true problem is that, in the real world, no one is perfectly informed. Those who have better information try to deceive those who have worse; but they are deceiving themselves that they know more than they do. If only one person were perfectly informed, there could never be a crisis – someone would always make the right calls at the right time. But only God is perfectly informed, and He does not play the stock market.

“The outstanding fact,” John Maynard Keynes wrote in his General Theory of Employment, Interest, and Money , “is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.” There is no perfect knowledge “out there” about the correct value of assets, because there is no way we can tell what the future will be like.

Rather than dealing with asymmetric information, we are dealing with different degrees of no information. Herd behavior arises, Keynes thought, not from attempts to deceive, but from the fact that, in the face of the unknown, we seek safety in numbers. Economics, in other words, must start from the premise of imperfect rather than perfect knowledge. It may then get nearer to explaining why we are where we are today.

(Akerlof's nobel prize lecture in pfd form is here; you can watch him deliver it here It is much broader than you may think discussing in a crisp manner issues that have been touched upon in class)

Couldn't resist....

Went to see it with my kids and I think I enjoyed it more than they did...

Pretty sad stuff

If you have (or, had) me in class you all know how upset I am about certain facets in our (greek) society and how disillusioned I get when some of these work their way through into school and manifest themselves not (only) in the behavior of 30 and 40 and 50 year old teachers but in the behavior of 16 or 17 year old kids.

Read this:

......One suggestive finding comes from a cross-cultural study carried out by three economists and published earlier this year in the journal Science. Simon Gächter, Benedikt Herrmann and Christian Thöni invited subjects in 16 cities across the world to play a “public goods” game, in which players had to choose, repeatedly, between contributing to a pot for the benefit of all or selfishly hoarding their own resources.

Earlier research had found that if players were given the option of punishing the selfish by removing their resources, they did so and near-full co-operation quickly emerged. Gächter and his colleagues found that, in many societies, the opposite occurred: rather than accepting their punishment and co-operating, those who had been punished tended instead to take revenge.

The results were striking: co-operative behaviour seemed to flourish in countries where market democracies were long established.

The Americans, Australians, Britons and Swiss were the least likely to inflict recriminatory punishment. Russians, Greeks and Saudis were most prone to reprisals. Co-operation was best sustained in the US, Denmark and Switzerland, and fell apart in Turkey, Saudi Arabia and Greece.

Cooperation requires trust. Remember what Dasgupta writes about trust in his 'Very Short Introduction to Economics'?

I wrote earlier in a post that you (the kids) are the future. Please change it and trasform this society to the better. You can start today.

The full article can be found here.

PS1: I just read this on that little 'text':

Dasgupta is supremely well qualified to write an overview of economics for the layman. Originally, he says, he had it in mind to lay out what he understood to be the research frontier. "But even though the analytical and empirical core of economics had growth from strength to strength over the decades," he writes, "I haven't been at ease with the selection of topics that textbooks offer for discussion (rural life in poor regions -- that is the economic life of some 2.5 billion people -- doesn't get mentioned at all, nor with the subjects that are emphasized in leading economic journals (Nature rarely appears there as an active player)." The result is a serious textbook treatment shaped around the lives of two ten-year-old "literary grandchildren," Becky in a small Midwestern suburb where her father works for a firm specializing in property law, Desta in a village in southwestern Ethiopia, where her father farms half a hectare of land.

Photographs depicting the wealth of a typical European or American family, laid out in the driveway of a two-car garage, contrasted with the meager personal belongings of a family arrayed before their thatch-roofed hut, have become common enough in introductory texts in recent years, but Dagupta follows his conceit throughout his book, demonstrating with particular force the extent to which institutional arrangements are at the heart of the differences between both places.

He concludes, "Perhaps the best that Becky's world can do for Desta's is to offer financial and technical assistance so as to promote and support local enterprises -- including those involving education and primary health care -- that people there are all too keen to create even as they see from a distance how people elsewhere have been able to improve their conditions of living. And perhaps the best that Desta's world can do for Becky's is to alert it to the enormous stresses economic growth there has put on Nature. There is, alas, no magic potion for bringing about economic progress in either world."

PS2: The above reminded me of a paper by PD. Read this:

I will be using the word "trust" in the context of someone forming expectations about those actions of others which have a bearing on her choice of action, when that action must be chosen before she can observe the actions of those others. Trust is of importance because its presence or absence can have a bearing on what we choose to do, and in many cases what we can do.

The clause concerning the inability to observe others’ actions at the time one chooses one’s own action is central. But it should be noted that this inability need not be due to one’s choice of action temporally preceding those of others. For example, it could be that what I ought now to do depends on whether you have done what you said you would do, in circumstances where I cannot now, or possibly ever, verify whether you have actually done it.

The paper is not the easiest to read but important parts are accessible and those of you who are a bit more socially sensitive and are willing to read (or, at least skim through) papers / books outside the 'required' may find the paper here. The 1 through 10 list in pp 9-11 is interesting - think about this country while reading it.

Quections for 2009

Dani Rodrik's Dec 31 post outlined the major issues - questions that in his opinion will define the way 2009 will unfold in the world.

Will the U.S. policy response be “bold” enough?

Barack Obama has promised that it will be, echoing at least part of FDR's famous call for “bold, persistent experimentation” at the height of the Great Depression in 1932. In particular, he will need to go beyond Keynesian policies of fiscal stimulus to heal the deep wounds to economic confidence that lie at the root of the present crisis. So far, confidence-building measures have been limited to financial markets, but the needs of Main Street are no less important. Workers who worry about being laid off are unlikely to go on a spending spree regardless of how much money fiscal stimulus puts in their pockets. Just as banks are hoarding cash, households will try to preserve wealth by increasing their saving. To counter this, incentives targeted directly at preserving employment will have to be part of the solution.

Will Europe get its act together?

This could have been Europe’s moment. After all, the crisis originated in the U.S. and left American policy focused on its domestic troubles, opening up room for global leadership by others. Instead, the crisis has demonstrated the deep divisions within Europe—on everything from financial regulation to the requisite policy response. Germany has dragged its feet on fiscal stimulus, stymieing what should have been the second leg of a globally-coordinated fiscal action plan. Alas, the best that can be hoped at this stage is that Europe will not undermine the global fiscal stimulus which even the International Monetary Fund—the guardian of fiscal orthodoxy—regards as absolutely essential.

Will China hold together?

China is a country of enormous tensions and cleavages beneath the surface, and these will find more occasion to erupt into open conflict in difficult economic times. Experts on China differ in their estimate of the rate of economic growth the country needs to create employment for the millions that flock into its urban areas every year. But it is virtually certain that China will fall short of this threshold in 2009. The question is whether policy actions to date will do enough to stem a socially and politically dangerous slowdown in the economy.

Will there be enough global economic cooperation?

When domestic needs become paramount, global economic cooperation suffers. But the costs of protectionism in trade and finance are especially large at moments like these. So far the International Monetary Fund has reacted with new-found vigor, establishing a much-needed short-term lending facility and warning against too little fiscal stimulus. The World Trade Organization, meanwhile, has wasted valuable time on the irrelevant Doha round. It should have focused its efforts on monitoring and implementing the commitment made by the Group of 20 countries not to raise trade barriers.

Each of the above should give us plenty to think about (to evaluate?). Each of the above could be easily transformed into an IB Economics long essay.

Happy New Year!

Well, this is the first post for 2009!

I wish you all the very best. I wish all IB (Economics) candidates 2009 to find themselves on their PPF (which with a wise allocation of their time now will have shifted outwards) and in their University of choice.

Above all, I wish you health and happiness. You are the future.

Dollar shift: While Americans spent, Chinese saved

" ..... but Americans did not use the lower-cost money afforded by Chinese investment to build a 21st-century equivalent of the railroads".

Another primer on Econ 101 for all IB Economics 2009 candidates. It brings together most of what we've learned throughout these (almost) 2 years.

Read it here.

PS: Free Exchange, also makes a reference (today, the 26th) to the article. It considers it a finger pointing argument:

EVERYONE is a victim; everyone is to blame. "The reckoning" continues as the New York Times singles out another scapegoat for the financial crisis. China gets added to the running list of actors without whom this economic snafu would not have been possible, joining the ranks of Wall Street executives, mortgage brokers, credit-rating agencies, homeowners, the White House, Senator Charles Schumer, former Senator Phil Gramm, the rest of Congress, and possibly you.

Read the comment by Yves Smith (his full post is here)for the 'other side'. If you feel a bit uneasy (you shouldn't by now after our class discussions) on how there are such different viewpoints, read this one by Greg Mankiw ('A Question about Learning Economics' a letter to Greg M. by a confused Econ major and Greg's answer)

Data Response Question: May08; HP3; Q1

This data question was different, interesting, a bit problematic (subquestion c) and had a rather demanding subquestion (d). As such I think that some thoughts on it could prove useful to you guys. If you haven't done it, try doing at least (d) in 20 minutes or less (since you will have already read these thoughts). You'll realize that it is still challenging. Bear in mind that what follows is not the expected 'answer'. There is no such thing (especially in d) as 'the' correct answer. Very many approaches can be considered fine by IB examiners. These are just some thoughts. Please refer to my 'how to' deal with data questions post . Lastly, standard level candidates should be aware that (a1), (c) and (d) could feature in a standard level exam.

May 2008 HP3 Q1 on vines and grapes:

a(i) equilibrium price is that price at which quantity demanded is equal to quantity supplied per period of time

a(ii) allocative efficiency exists if just the right amount of a good is produced from society’s point of view and thus scarce resources are allocated in the best possible way; this occurs if, for the last unit produced, P = MC.

b. Removing an indirect ad valorem tax implies that production costs will be lower so supply will increase, shifting and swiveling to the right from St to S. (i.e. not a parallel shift)

As a result the market price will decrease from P1 to P2 and quantity demanded will in-crease from Q1 to Q2 per period.

c. Since the resources (land, labor, capital and entrepreneurship) available to the Australian economy have not decreased and neither has the available technology changed, potential output (the combinations of goods that the economy can produce if all resources are fully employed given technology) has remained unchanged and thus the PPF has not shifted. Assuming that the economy was originally operating on its PPF (some point A), now that vines are pulled out fewer grapes can be produced in the short run moving to a point inside with fewer grapes (g2) and the same amount of apples produced (point B). When the land is ready for some other good to grow (apples) then there will be a movement to point C with more apples (a2) fewer (g2) grapes than originally. In other words, there has been a reallocation of resources (e.g. land) away from one good (grapes) towards the production of another good (e.g. apples)

Alternatively, if vines are considered a ‘factor’ of production, then a PPF with grapes on one axis and other goods on the other could pivot inward on the side of the grape axis.

d. You are asked to evaluate the role of falling (grape) prices in the reallocation of resources. First, think of the theoretical model: In free, competitive markets, which goods are produced, in what amounts and consequently how resources are allocated is dictated by demand and supply conditions. When market conditions change it is the changes in relative prices that that has ‘signaling power’ and thus leads to changes in the behavior of producers and consumers.

In the specific setup, the market price for grapes is falling as ‘large crops’ coupled with ‘a slower than expected export market for Australian wine’ (paragraph 1). A fall in price signals that too much of the good is available in the market and implies a decrease in profits (‘producers are suffering with falling profit levels’ (paragraph 4); you could visualize here a perfect competitor with his AR (MR, dd) curve falling). Incentives have changed as a result o the price change. Some growers will be making losses and thus exit the industry. Others will be forced to become more efficient: ‘there is a need for grape growers to find substitute products to grow, and for a vine retirement program where unwanted varieties are pulled out and other varieties planted’ (paragraph 3).

Up to this point you are describing the role of a relative price change. Now you should evaluate this role. Can, or do, falling prices on their own do the trick of resource reallocation?

Well, in paragraph 3 the existence of an ‘industry spokesman’ is revealed who is providing information to industry members. This implies a first weakness of relative price changes as a means of reallocating resources. Market participants (farmers) do not possess the ‘perfect information’ the model assumes. They may not be aware of the severity of the problem and of what other market opportunities exist for them to move resources into. Moreover, resources may be geographically or occupationally immobile which would further complicate the process.

Then, in paragraph 5 another issue is revealed: ‘It is estimated that it will take at least another two years to clear the oversupply of wine, with exports, hopefully, growing significantly to achieve a balance between supply and demand’. This information implies that maybe some of the growers should try to survive the current crisis as in 'two years’ the oversupply will clear. Price movements typically reflect current market conditions and often fail to account for future conditions. As a result, perhaps too many vines will be pulled out – more than the situation warrants.

Lastly, the situation now is exacerbated by ‘..an appreciating Australian dollar’ which ‘is making it difficult to export more wine’ (paragraph 5). Since the exchange rate system is flexible (as the AUD is ‘appreciating’) and we know that foreign exchange markets exhibit significant volatility the appreciation described may be reversed sooner than expected.

It thus seems that despite the fact that relative price changes are a very powerful and efficient mechanism to allocate and reallocate scarce resources, there are imperfections that relate to scarce information concerning present and future market conditions as well as immobilities that perhaps necessitate the existence of industry and government assistance in the decision making process of the individual producers.

Not a very easy (d) but bear in mind that this question (how are resources allocated in a market economy) shows up very often as a short for the higher level and as a long for the standard level!

Who benefits from ipods?

If you have one, you obviously do benefit, but that's the consumption side of the story. What about the production side? Your ipod was not manufactured in the US so, in terms of employment numbers, does the US benefit?

Greg Linden, Jason Dedrick and Kenneth Kraemer ... tally the number of jobs and wages associated with the production, development and distribution of all Apple iPods in 2006. Apple (an American company) invented the iPod, but they, and the intermediate goods they require, are mainly manufactured abroad. So other than enjoying more music, have Americans benefited from the creation of iPods?

The answer is yes. The authors found iPods employed 41,170 people worldwide. About 27,000 of those jobs went overseas, but most of those were the low-wage and low-skill jobs involved in production. Only 30 Americans had jobs involved in iPod production. But 13,890 jobs were created in the engineering or retail sector. These Americans earned $753m from iPods, while overeases employees earned $318m. Americans earned more because Apple kept the high-skill jobs (the R&D side) at home and sent its manufacturing abroad. But America's lower-skill workers also benefited, mainly in the retail, non-professional sector. These jobs earned American workers more than $220m.

This interesting discussion was found at "Free exchange", the blog maintained by the Economist magazine. Check it out here.

Economists missed the brewing crisis

This article was brought to my attention by my colleague John L. Tomkinson (History and TOK) and I thank him as it is very interesting for all of us doing IB Economics and even more so for those planning to major in Economics somewhere in the UK or the US.

The full title of the article is: Paradigm lost: Economists missed the brewing crisis. Now many are asking: How can we do better? It starts by noticing that everyone is baffled by how the current crisis started and was transmitted throughout markets and economies:

The vast majority of us, after all, are not experts. But academic economists are. And with very few exceptions, they did not predict the crisis, either. Some warned of a housing bubble, but almost none foresaw the resulting cataclysm. An entire field of experts dedicated to studying the behavior of markets failed to anticipate what may prove to be the biggest economic collapse of our lifetime. And, now that we're in the middle of it, many frankly admit that they're not sure how to prevent things from getting worse.

The whole article is thought provoking but, if you aren't about to read the whole thing here then, at least read this, as it should sound familiar:

Already, the crisis is reshaping long-running debates. It has chastened believers in the self-correcting abilities of the free market - Alan Greenspan said as much before Congress in October - and emboldened those who see the need for more active government intervention.

In a sense, it's a debate that has been seesawing back and forth from crisis to crisis over the past century. Classical economics was devastated by the Great Depression, and in the years afterward gave way to the ideas of the British economist John Maynard Keynes: that individually rational economic decisions could add up to collectively disastrous consequences, that the "stickiness" of prices and wages could lead to long-term unemployment and stagnation, and that the government, as a result, has to step in to kick-start the economy.

The stagflation of the 1970s, while mild compared with the Depression, swung the pendulum back. It was Milton Friedman, a sharp critic of Keynesianism and a fervent advocate of unfettered free markets, who solved the seeming paradox of simultaneous inflation and high unemployment by realizing the deadening power of people's expectation of future inflation, and it was Friedman's proposed solution - sharply restricting the money supply - that eventually, albeit painfully, solved the problem.

Today's crisis has brought Keynes back to the center of the discussion, but some economists also see it driving the field into new territory. Up until very recently, the study of market bubbles was marginalized - there was no widely accepted definition of what a bubble was, and some economists, believers in the complete rationality of markets, argued that bubbles didn't even exist. Today, however, there is a growing sense that understanding bubbles is vital to understanding markets - among those making the case is Federal Reserve chairman Ben Bernanke, who, as head of the Princeton economics department, made a point of hiring young economists interested in the topic.

Over the same time period, the field of so-called behavioral economics has risen to prominence, led by, among others, Thaler, Laibson, and Robert Shiller, a Yale economist who warned of both the housing bubble and, in 2000, the dot-com bubble. By borrowing the insights and methods of psychology, behavioral economics focuses on all the ways in which humans fail to act as the rational, self-interested beings that economic models call for - we aren't good at thinking about the future, we're susceptible to peer pressure, we overestimate our abilities and underrate the odds of bad things happening. It's a set of traits that describes perfectly the behavior of many of the people who, in a cascade of self-defeating decisions, helped create the subprime crisis.

Thanks, John.

OPEC is turning into an increasingly irrelevant organization!

That's what an oil analyst recently said!

If you want a primer on cartels, OPEC, the incentive to cheat, stability etc please read this (easy) Business Week article: OPEC Loses Its Muscle.

Also, read (again?) our October 21 post on OPEC: 'Between a rock and a hard place'.

Development related reading

I promised in class to point out to you interesting, short and easy for you to understand articles written by the very best in the world on development related issues.

Please save, print and read these articles trying perhaps to make short summaries of their most important points.

We'll discuss some of these in class. Try using incorporating them into your essays.

This one is by Dani Rodrik: Let Developing Nations Rule

He claims that the current crisis may weaken the US and the EU to such an extent that the weight of the bigger developing countries will increase permitting them to influence the 'rules of the game'.

To make the best of this outcome, developing nations will have to have a good sense of their interests and priorities. So, what should they seek?

First, they should push for new rules that make financial crises less likely and their consequences less severe. Left to their own devices, global financial markets provide too much credit at too cheap a price in good times, and too little credit in bad times. The only effective response is counter-cyclical capital-account management: discouraging foreign borrowing during economic upswings and preventing capital flight during downswings.

So, instead of frowning on capital controls and pushing for financial openness, the International Monetary Fund should be in the business of actively helping countries implement such policies. It should also enlarge its emergency credit lines to act more as a lender of last resort to developing nations hit by financial whiplash.

The crisis is an opportunity to achieve greater transparency on all fronts, including banking practices in rich countries that facilitate tax evasion in developing nations. Wealthy citizens in the developing world evade more than $100 billion worth of taxes in their home countries each year, thanks to bank accounts in Zurich, Miami, London, and elsewhere. Developing countries’ governments should request and be given information about their nationals’ accounts.

Developing nations should also push for a Tobin tax – a tax on global foreign currency transactions. Set at a low enough level – say, 0.25% – such a tax would have little adverse effect on the global economy while raising considerable revenue. At worst, the efficiency costs would be minor; at best, the tax would discourage excessive short-term speculation.

The revenues collected – easily hundreds of billions of dollars annually – could be spent on global public goods such as development assistance, vaccines for tropical diseases, and the greening of technologies in use in the developing world. The administrative difficulties in implementing a Tobin tax are not insurmountable, as long as all major advanced countries go along. It would then be possible to get offshore financial centers to cooperate by threatening to isolate them.

Developing nations also need to enshrine the notion of “policy space” in the World Trade Organization. The goal would be to ensure that developing countries can employ the kind of trade and industrial policies needed to restructure and diversify their economies and set the stage for economic growth. All countries that have successfully globalized have used such policies, many of which (e.g., subsidies, domestic-content rules, reverse engineering of patented products) are currently not allowed under WTO rules.

Not a very easy article for the IB economics level but I'm sure you can benefit by reading it. We'll talk about it in class.

Internal Assessment

I expected to collect commentary #4 from 30 students today but I only collected 14. A bit disappointing. Two things:

1. A big thank you to those who have learned to respect a deadline
2. I do expect the rest to hand it in by Monday, the 29th. Please drop it off at the front desk (Ms. Eleni's desk).

Has Global Stag-Deflation Arrived?

This is the title of an article by Nouriel Roubini, Professor of Economics at the Stern School of Business, NYU, I just read at Project Syndicate.

A must for IB Economics candidates as it presents the problems and policy options available to Governments and Central Banks at these difficult times.

'With a global recession a near certainty, deflation – rather than inflation – will become the main concern for policymakers. The fall in aggregate demand while potential aggregate supply has been rising because of overinvestment by China and other emerging markets will sharply reduce inflation. Slack labor markets with rising unemployment rates will cap wage and labor costs. Further falls in commodity prices – already down 30% from their summer peak – will add to these deflationary pressures.

Policymakers will have to worry about a strange beast called “stag-deflation” (a combination of economic stagnation/recession and deflation); about liquidity traps (when official interest rates become so close to zero that traditional monetary policy loses effectiveness); and about debt deflation (the rise in the real value of nominal debts, increasing the risk of bankruptcy for distressed households, firms, financial institutions, and governments).

With traditional monetary policy becoming less effective, non-traditional policy tools aimed at generating greater liquidity and credit (via quantitative easing and direct central bank purchases of private illiquid assets) will become necessary. And, while traditional fiscal policy (government spending and tax cuts) will be pursued aggressively, non- traditional fiscal policy (expenditures to bail out financial institutions, lenders, and borrowers) will also become increasingly important.

In the process, the role of states and governments in economic activity will be vastly expanded. Traditionally, central banks have been the lenders of last resort, but now they are becoming the lenders of first and only resort. As banks curtail lending to each other, to other financial institutions, and to the corporate sector, central banks are becoming the only lenders around.

Likewise, with household consumption and business investment collapsing, governments will soon become the spenders of first and only resort, stimulating demand and rescuing banks, firms, and households. The long-term consequences of the resulting surge in fiscal deficits are serious. If the deficits are monetized by central banks, inflation will follow the short-term deflationary pressures; if they are financed by debt, the long-term solvency of some governments may be at stake unless medium-term fiscal discipline is restored.'

The full article is here.

Xmas Assignment Candidates 2009

These are the Long and Short Essays I'd like you to complete over Xmas break.

Remember you should first read the section on development and then read the list of long essays. Choose one. Then research the key issue by checking out the net. Use advanced google. Remember also the World Bank, the UNDP site, the OECD development pages, the UN Millennium goals page, the WTO trade and development page, the Center for International Development at Harvard as well as specific pages/ posts that I recommend such as many of the Jeff Sachs articles found at the Project Syndicate site.

In any case, here they are:

Long Essays

1. Either May 2008 on (a) measuring development and (b) evaluating whether faster growth is the most effective way to pursue development or Nov 2007 on explaining 3 institutional factors that may contribute to growth and (b) evaluating whether growth leads to development.
2. Either #24 on (a) describing main barriers to development and (b) evaluating whether a more equitable income (and wealth) distribution promotes development or, Nov 2005 on (a) explaining 2 barriers to growth and (b) evaluating strategies to overcome the barriers mentioned in (a)
3. Either #27 on (a) explaining the different forms of aid and (b) evaluate whether aid is effective or May 2007 (very similar)
4. Either Nov 2006 on (a) why firms turn multinational and (b) evaluating whether FDI is effective in promoting growth and development

Short Essays
1. #39 on why indebtedness may hinder growth and development (or, #32)
2. #38 on explaining the difference between inward and outward oriented growth (or, #8)
3. #36 on why overdependence on primary products may be a dead end
4. #24 on sustainable development (or, #20 or, #37)
5. #23 on the gender specific benefits of educating girls
6. #28 on the types of growth to avoid
7. #34 on the difference between growth and development (or, #12, or#35)
8. #29 on the importance of human capital in the development process


This is the newest list of long essays and this is the list of short essays.

Enjoy!

HP3 (and SP2): A 'how to' short manual

Note: This list is intended for my kids at the Moraitis School IB Program. If you are not an IB2 candidate at The Moraitis School please bear in mind that your teacher's advice is what you should follow. Many colleagues may disagree with what I say below. Constructive criticism is much appreciated so feel free to comment.

IB Economics: On HP3 (and SP2)

1.Do (a), (b) and (c) in 15 minutes without having read the extract. Only very few (b) or (c) questions require that you read a paragraph or two from the extract. If that is the case, the question usually directs you to the relevant paragraph(s).

2.For question (a): each definition should not be more than 2-4 lines long. Never explain more than is necessary. Be succinct. Also remember that a 'vague' explanation accompanied by a relevant and correctly drawn diagram may earn 2 points.

3.For (b) and (c) questions that explicitly ask for an ‘appropriate diagram’ remember that you earn 2 points for the diagram and 2 points for the explanation.

4.Thus, explanations must be brief and to the point, referring to the specifics of the diagram you have drawn (explanations should not be more than 5 - 10 lines maximum). The diagram must be large enough, clear, well labelled and drawn using a pencil and a ruler. You could read from my 'Economics Study Guide' p. 147 on how to effectively construct diagrams.

5.If a diagram is not required, you could still employ one if you consider it directly relevant, as diagrams are in general rewarded. In such (b) or (c) questions (that do not require a diagram) you may need to write anywhere between 8 - 15 lines maximum.

6.Once done with (a), (b) and (c), devote the remaining 25 minutes on (d)

7.First, carefully read, making sure you clearly understand, what you are asked to evaluate (rephrase the question if necessary)

8.Brainstorm for a couple of minutes, thinking of the different stakeholders, the different perspectives and the economic theory relevant to the specific issue

9.Then, go to extract and start reading it, noting with a pencil the phrases / sentences that you could use in (d).

10.Make sure you write at least 2.5 to 3 (I.B.) pages on question (d)

11. Make sure you use quotations and data from the extract to support what you write. Use quotation marks and in a paranthesis the paragraph from which the qute is drawn. You need not refer to the text for all the points you make. Make sure though that your evaluation is 'not in a vat' but that it is directly relevant to the specifics of the extract. An excellent evaluation without references can not earn more than 5 points. You could read from my 'Economics Study Guide' pp. 145-146 on how to evaluate.

12.Make sure you separate each point you explain in your evaluation with a blank line as it greatly helps the examiner in his/her assessment.

13.Use a 3B pencil (and a ruler) for your diagrams (also have a colored pencil with you – not red or green)

14.Have a watch and place it on your desk: HP3 (and SP2) are all about time management.

15. Copy and paste the above onto a word file and print

16. Do as many past papers you can under test conditions: do several in 40 minutes and also groups of 3 in 2 hours. You should also try doing separately (a),(b) and (c) in 15 and only (d)'s in 25. Practice is the key to success in this exam.

Evaluating the crowding-out argument

When in a macro question you are asked to evaluate expansionary fiscal policy (deficit spending) it is expected that you include in your discussion the 'crowding-out' effect argument: the increased government spending is ineffective because private investment will decrease (will be crowded out) as higher borrowing by the government to finance these additional expenditures will increase interests rates.

Paul Krugman has an absolutely excellent piece on why the validity of this argument depends a lot on the specifics of the overall macroeconomic picture in which a government decides to use the Keynesian recipe to jump start the economy:

Right now there’s intense debate about how aggressive the United States government should be in its attempts to turn the economy around. Many economists, myself included, are calling for a very large fiscal expansion to keep the economy from going into free fall. Others, however, worry about the burden that large budget deficits will place on future generations.

But the deficit worriers have it all wrong. Under current conditions, there’s no trade-off between what’s good in the short run and what’s good for the long run; strong fiscal expansion would actually enhance the economy’s long-run prospects.

The claim that budget deficits make the economy poorer in the long run is based on the belief that government borrowing “crowds out” private investment — that the government, by issuing lots of debt, drives up interest rates, which makes businesses unwilling to spend on new plant and equipment, and that this in turn reduces the economy’s long-run rate of growth. Under normal circumstances there’s a lot to this argument.

But circumstances right now are anything but normal. Consider what would happen next year if the Obama administration gave in to the deficit hawks and scaled back its fiscal plans.

Would this lead to lower interest rates? It certainly wouldn’t lead to a reduction in short-term interest rates, which are more or less controlled by the Federal Reserve. The Fed is already keeping those rates as low as it can — virtually at zero — and won’t change that policy unless it sees signs that the economy is threatening to overheat. And that doesn’t seem like a realistic prospect any time soon.

What about longer-term rates? These rates, which are already at a half-century low, mainly reflect expected future short-term rates. Fiscal austerity could push them even lower — but only by creating expectations that the economy would remain deeply depressed for a long time, which would reduce, not increase, private investment.

And:

One more thing: Fiscal expansion will be even better for America’s future if a large part of the expansion takes the form of public investment — of building roads, repairing bridges and developing new technologies, all of which make the nation richer in the long run.

(check out on this the 'tip' on page 78 of my econ guide)


The full article is here.

Morals and the Meltdown

There are quite a few of you in my class who are philosophically inclined, so to speak. I was just checking out Project-Syndicate (which you should bookmark and check out on your own from time to time) and I stumbled on a very interesting article by Robert Skidelsky.

Quoting from the article:

After World War I, H.G. Wells wrote that a race was on between morality and destruction. Humanity had to abandon its warlike ways, Wells said, or technology would decimate it.

Economic writing, however, conveyed a completely different world. Here technology was deservedly king. Prometheus was a benevolent monarch who scattered the fruits of progress among his people. In the economists’ world, morality should not seek to control technology, but should adapt to its demands. Only by doing so could economic growth be assured and poverty eliminated. Traditional morality faded away as technology multiplied productive power.

We have clung to this faith in technological salvation as the old faiths waned and technology became ever more inventive. Our faith in the market – for the market is the midwife of technological invention – was a result of this. In the name of this faith, we have embraced globalization, the widest possible extension of the market economy.

For the sake of globalization, communities are de-natured, jobs off-shored, and skills continually re-configured. We are told by its apostles that the wholesale impairment of most of what gave meaning to life is necessary to achieve an “efficient allocation of capital” and a “reduction in transaction costs.” Moralities that resist this logic are branded “obstacles to progress.” Protection – the duty the strong owe to the weak – becomes Protectionism, an evil thing that breeds war and corruption.

And:

As long as we rely on technical fixes to plug moral gaps and governments rush in with rescue packages that enable the merry-go-round to start up again, we are bound to keep lurching from frenzy to frenzy, punctuated by intervals of collapse. But, at some point, we will confront some limit to growth.

Worth your time.