Container ship ladder and other quirky economic indicators

Climbing Ladder on a Container Ship
With the downturn in global trade the international transport industry has been very much affected. Those that have been associated with the distribution of goods get an early indication of the slowdown in global growth. The obvious indicators are: idle cranes, queues of merchant ships dwindle etc. But what about the speed of cargo ships and the length of ladders to climb aboard?
When the world economy was “steaming” ahead the captain of a merchant ship said that they cruised at 20 knots but in a recession we slowed to 16 knots. A harbour pilot summed up the state of world trade by the length of the ladders that he climbs on the sides of ships.

A long climb up the ladder signifies that the ship is high in the water and exports are correspondingly low.
A short climb up the ladder signifies that the ship is low in the water and exports are correspondingly high.

The seafarers say that they take air to China before they load up with goods for the US.

The Number of Cranes
As mentioned in my previous post, cranes are a good indicator. A tally of tower cranes can tell us about economic activity as they lift materials like concrete and steel as high as 80 stories. By counting cranes, we can get an idea of where economic activity in that area has been heading. More cranes suggest more demand for housing and offices in the market, while simultaneously signalling healthy employment within the construction sector.

The Briefcase Indicator
Alan Greenspan (former US Fed Chariman) had the ‘Briefcase Indicator’. Cameras from CNBC would follow him on the mornings of Federal Open Market Committee meetings as he arrived at the Fed. The theory went that if his briefcase was thin his mind was untroubled and the economy was well. But if it was stuffed full, rumour had it that he was up all night and a rate hike was on the cards. For the record Greenspan explained in his book “The Age of Turbulence” that the size of his briefcase was solely a function of whether he packed his lunch.

More Mosquito Bites
In Maricopa County, Arizona, there are a vast number of house that have been abandoned by their owners – forelosures. Within these properties are swimming pools or ponds which are now unattended. Before the financial crisis local authorities only treated 2,500 but in 2009 after the housing market collapse 4,000 were treated.

Cardboard Box Index
The Cardboard Box Index offers a unique perspective on economic activity by examining the demand for cardboard boxes, a key packaging material for various products. When manufacturing and consumer spending increase, the demand for cardboard boxes rises accordingly. Conversely, a decline in cardboard box demand may signify a slowdown in manufacturing and a decrease in consumer confidence.

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GDP per capita vs Happiness – 2023

Higher incomes may make life easier with an ability to afford certain items whether it be a new car or household appliance but this is only one variable in predicting happiness. Other variables, such as social support, life expectancy, freedom, generosity, and the absence of corruption, also help explain varying levels of happiness between countries. The Easterlin Paradox In the mid 1970s Richard Easterlin drew attention to studies that showed that, although successive generations are usually more affluent that their parents or grandparents, people seemed to be no happier with their lives. It is an interesting paradox to study when you are writing about measuring economic welfare and the standard of living.

The World Happiness Report for 2023 advocated policies that not only foster economic growth but enhance the quality of life. Governments can adopt a more holistic approach to policy-making, ensuring that progress is measured not solely by material wealth but by the well-being of their citizens. While higher GDP per capita goes together with higher life satisfaction, there are other factors that help explain the striking differences between some examples – see image below from the IMF.

Source: F&D March 2024 – IMF

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Causes of recessions and how do you manipulate the economy for a ‘soft landing’?

Below is a very good video from CNBC that covers the main causes of recessions – overheated economy, asset bubbles and black swan events. Good analysis of soft and hard landings as well as the wage price spiral effect.

“History teaches us that recessions are inevitable,” said David Wessel, a senior fellow in economic studies at The Brookings Institution. “I think there are things we can do with a policy that makes recessions less likely or when they occur, less severe. We’ve learned a lot, but we haven’t learned enough to say that we’re never going to have another recession.” As the nation’s authority on monetary policies, the Federal Reserve plays a critical role in managing recessions. The Fed is currently attempting to avoid a recession by engineering what’s known as a “soft landing,” in which incremental interest rate hikes are used to curb inflation without pushing the economy into recession.

Per capita low-carbon energy consumption vs GDP per capita

Interesting graph showing the relationship between GDP growth and the per capita low-carbon energy consumption. Norway is leading the way with its new target is to reduce emissions by at least 55 % by 2030. The country has a low-carbon energy mix thanks to its widespread use of renewables and in 2020 prohibited use of fossil oil for heating in existing buildings and in new buildings. It is making progress towards its goal of registering all new passenger cars and light vans as zero emission vehicles by 2025. Other Scandinavian countries Finland and Sweden also feature in a positive way. On the other side there is Ireland which has a high GDP per capital but a limited per capita low-carbon energy consumption. Luxembourg is further right and it uses a lot of fossil fuels driven by a high demand for transportation fuels, notably from the volume of freight trucks and commuters transiting through the country.

Source: Our World in Data

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Natural Resources v GDP

The Economics of Biodiversity by Sir Partha Dasgupta was published in February 2021 and was a wake up call for all of us. Sir Partha says nature must be recognised as an asset and that our traditional measure of economic prosperity – Gross Domestic Product – is no longer fit for purpose. Basically all 7.8 billion of us is on a collision course with the planet.

“The problem with GDP is that it doesn’t include the depreciation of capital and one of the natural capital, or nature, which is somewhat different from buildings and roads in that you can really depreciate it very fast.”

Between 1992 and 2014 there was a 40% fall in the stock of natural capital per person – water, food, air etc. See graph below.

Global Wealth Per Capita, 1992 to 2014

Source: The Economics of Biodiversity by Sir Partha Dasgupta

Since 1950 the global economy has grown 14 fold and with the increase in prosperity has come the cost to our natural environment. With our current consumption we need an earth that is 1.6 times larger. Although there has been moves to slow the rate of climate change the progress needs to be accelerated. Larry Elliott in The Guardian looked at three ways:

• Firstly you could simply stop the burning of fossil fuels or international travel now or in the near future.
• Secondly you leave the issue of climate change to the markets: governments could stop subsidising the use of fossil fuels but otherwise leave it to inventiveness of the private sector to come up with solutions.
• A third approach is to have a partnership between the government and the private sector. A previous example of this was the announcement by President Kennedy in 1961 that the US would put a man on the moon by the end of the decade. Larry Elliott quotes Mariana Mazzucato’s book ‘Mission Economy’ in which she states that by focusing on the immense power of governments to shape markets, capitalism itself can be remade. Mazzucato aims to infuse capitalism with public interest rather than private gain.

Below is a video from CNBC about climate change which is already taking a financial toll on the planet, with extreme weather events costing the global economy $146 billion in 2019, according to insurer Swiss Re. Also an interview with IMF Managing Director Kristalina Georgieva about how governments and business can fight back.

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Japan’s monetary and fiscal policy are at odds with each other

The Bank of Japan (Japan’s central bank) and the Japanese government seem to be moving in opposite directions with regard to monetary and fiscal policy. On the one hand you have the Bank of Japan exiting its long-running experiment with ultra-loose monetary policy (low interest rates) with a depreciating currency (yen) rising bond yields and persistent inflation. Therefore the economy is preparing for positive interest rates which is normal for monetary policy. On the other hand you have the government implementing an expansionary fiscal policy.

Japan has a headline inflation rate above 2% for many months but there could be a delay in tightening as a lot of the pressure on prices is imported with local wages still not rising to match the inflation target over the long term. Also whilst inflation can be tackled with higher interest rates Japan has little chance to cut rates if prices undershoot. Consequently it makes sense to have a tighter monetary policy with the chance of higher inflation.

Adapted from CIE A Level Revision Book – Susan Grant

What is perplexing is the government’s expansionary fiscal policy which is estimated to be 3% of GDP. It consists of large tax cuts and rebates for households which appears to be more political than economic as an unpopular government is trying to please an unhappy electorate. Over the last 30 years Japan has required huge fiscal stimulus to achieve positive economic growth and avoid the risk of deflation. A positive inflation rate means that the business cycle could be managed by using interest rates and therefore less pressure on the government budget deficit to keep the economy going – injecting money in the circular flow of the economy.

Adapted from CIE A Level Revision Book – Susan Grant

Although it remains important for the central bank to avoid tightening monetary policy too early it seems irrational that the government should implement an expansionary fiscal policy. This makes the Bank of Japan’s job even harder and also uses up fiscal ammunition in the event of a global downturn.

Source: Japan’s fiscal and monetary policies are moving in opposite directions – FT November 10th 2023

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A2 Economics – The Accelerator

With the A2 multiple-choice paper fast approaching in the southern hemisphere, here is a note on the accelerator. The accelerator theory states that investment is determined by the RATE AT WHICH INCOME, AND HENCE OUTPUT, CHANGES OVER TIME. The principle states simply that unless the rate of increase in consumption is maintained, the previous level of investment will not be maintained.

This theory assumes that firms try to maintain some constant relationship between the level of output and the stock of capital required to produce that output. In other words, we assume a constant capital-output ratio which can be expressed in either physical terms or money terms. The accelerator helps us to understand how small changes in demand in one sector can be magnified and spread throughout the economy. The example below assumes that the firm starts with 8 machines each year and 1 machine wears out each year and that each machine can produce 100 units of output per year. In the second year, demand rises for capital goods rises by 200% (from 1 to 3). When the rate of growth of demand for consumer goods slows in year 4, demand for capital goods falls. In year 6 demand drops and they is no requirement for any investment.

Limitations of Accelerator:
* Firms can meet output with stocks – may not need investment
* Changes in technology may mean firms don’t need to invest in as much capital as before
* Firms need to be convinced that demand is long-term to warrant investment
* Limited supply of technology available

Adapted from AS and A Level Revision book – Susan Grant

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National Income – USA v NZ

A government measures a country’s total output to assess the performance of the country. An economy is usually considered to be doing well if its output is growing at a sustained and sustainable rate. Economic growth has the potential to increase people’s living standards. If an economy is growing at a slower rate than it is considered capable of, a government is likely to introduce policy measures to stimulate the economy.

National income statistics are used to compare countries’ economic performance and to give a perspective to key economic indicators. For instance:

• 2018 the value of output of New Zealand US$280 billion
• 2019 the value of output of New Zealand increased to US$295 billion

• 2018 the value of output of USA US$19.52 trillion
• 2019 the value of output of USA increased to US$20.58 trillion

The US had a greater absolute increase in output but a smaller percentage increase than New Zealand as it was starting from a larger base (US$19.52 trillion compared with US$280 billion). See mindmap below with measures/characteristics of National Income.

GROSS DOMESTIC PRODUCT (GDP) Under new definitions introduced in the late 1990s, Gross Domestic Product is also known as Gross Value Added. It is defined as the value of output produced within the domestic boundaries of the NZ over a given period of time, usually a year. It includes the output of foreign owned firms that are located in NZ, such as the majority of Trading Banks in the market – ASB, National, ANZ etc. It does not include output of NZ firms that are located abroad.

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NZ dairy farmers face tougher times with forecast payout

Last week’s global dairy auction saw milk prices fall to 5 year lows with the price of whole milk powder falling to $2,875 per tonne which is a 10.9% drop from the previous event. This price indicates a current surplus of fresh milk in China, resulting in elevated levels of local production of whole milk powder, and reducing near-term whole milk powder import requirements – reduced demand from China. With this in mind Fonterra has cut its farmgate milk price forecast and expects to pay farmers between $6 and $7.50 per kilogram of milk solids this season. A lower milk price is going to further squeeze dairy farmers with DairyNZ estimating the average farmer would need $7.51 per kgMS to break even. It is estimated that the drop in milk price will lower farmer incomes by about $2.2 billion, denting rural spending and weighing on the wider economy.

These prices are generated by the GlobalDairyTrade which is an auction platform for internationally traded commodity dairy products. How does it work?

GlobalDairyTrade trading events are conducted as ascending-price clock auctions run over several bidding rounds.  In each auction a specified maximum quantity of each product is offered for sale at a pre-announced starting price. Bidders bid the quantity of each product that they wish to purchase at the announced price. If the price of a product increases between rounds, to ensure their desired quantity a bidder must bid their desired quantity at the new, higher price. Generally, as the price of a product increases, the quantity of bids received for that product decreases. The trading event runs over several rounds with the prices increasing round to round until the quantity of bids received for each product on offer matches the quantity on offer for the product (as shown in the diagram below). Each trading event typically lasts approximately 2 hours.

Bidders cannot join a trading event part way through: they must participate in round 1 and can only maintain or decrease their total bid quantities from that point. Products can be purchased over different delivery time periods, known as contract periods.

Click below for more information.

GlobalDairyTrade

Women’s Football World Cup and the multiplier

I blogged on this topic earlier in the year but thought it topical with the coverage of the Women’s Football World Cup in Australian and New Zealand. The tournament has been a great success and by the time it ends, more than 700,000 fans will have attended the 29 games in New Zealand, and more than 1.9 million fans across New Zealand and Australia. As with any sporting event or otherwise organisers will mention the ‘multiplier’ (part of NCEA 3.5 and A2 Economics courses) effect in the flow-on benefits for every dollar spent at these events. There has been much talk of the financial benefits to the NZ economy and Fifa estimated the income from overseas and domestic tourism from the event will tally up to $132m.

Think of the multiplier effect as a still pond. Women’s Football World Cup – the direct impact of spending on the World Cup is like a stone hitting the water and creating ripples which will get smaller and smaller. With spectators coming to Auckland to watch a game they will make additional spending on accommodation, transport, food, tourist attractions etc. Where a hotel makes a lot of money form the event they may chose to extend the numbers of rooms which means they will have to employ contractors who will receive more income. The contractor might spend this additional income on a new vehicle for the business which then adds income to the car dealership – and it goes on with the ripples getting smaller and smaller.

Economic forecasters tend to use a simple formula to estimate the multiplier effect of sports event. They will estimate the number of spectators, how long they will stay and what they, on average, will spend whilst at the event.

Problems of forecasting
Unrealistic projections of the number of visitors or their potential spending will lead to inaccurate multiplier effects. Factors that might overestimate the true economic impact of a sporting event.
Substitution effect: this happens when the spending on a sporting event would have been spent elsewhere in the local economy and therefore doesn’t generate new economic activity.
Crowding out: crowds and congestion may dissuade other economic activity from occurring. For example London Olympics 2012 590,000 visitors arrive in connection with the Olympics but the number of visitors fell by 1 million between summers of 2011 and 2012.
Leakages: higher costs for restaurants, hotels etc associated with hosting the event doesn’t necessarily mean that employees working in those areas will be paid more. Also where there are guest workers from overseas the money is less likely to be recirculated. For some venues on the coast cruise ships have been used but this is only during the event.

Research into the impact of sporting events whether it would be the Champions League Final, World Cup, Olympic Games etc has found there is little short-run economic effect on the host city. The table above shows the research before and after sporting events with conflicting data. Some economists joke that if you really want to know what the true economic impact of a sporting event is, just take whatever number the promoters give you and then move the decimal point one place to the left.

Source: The Economics of Sport (2018) – M. Leeds, P. Von Allmen and V. Matheson

The theory behind the multiplier.
Consider a $300 million increase in business capital investment. This will set off a chain reaction of increases in expenditures. Firms who produce the capital goods that are ultimately purchased will experience an increase in their incomes. If they in turn, collectively spend about 3/5 of that additional income, then $180m will be added to the incomes of others. At this point, total income has grown by ($300m + (0.6 x $300m). The sum will continue to increase as the producers of the additional goods and services realise an increase in their incomes, of which they in turn spend 60% on even more goods and services. The increase in total income will then be ($300m + (0.6 x $300m) + (0.6 x $180m). The process can continue indefinitely. But each time, the additional rise in spending and income is a fraction of the previous addition to the circular flow.

The value of the multiplier can be found by the equation ­1 ÷ (1-MPC)
You can also use the following formula which represents a four sector economy
1 ÷ MPS+MRT+MPM

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Using photographs to teach cross-country differences in real GDP per capita

I came across this novel idea of using photographs to teach cross-country differences in real per-capita GDP in the Journal of Economics Teaching. It draws on over 44,000 internationally comparable photographs (of households and their living conditions). Most courses focus on how real GDP per capita is calculated, the concept (and the data underlying it) may be disconnected from what students know (e.g., a home and its defining characteristics, the availability of utilities, occupants’ health and hygiene, quality of food, etc.) or can relate to (e.g., educational attainment, political regime characteristics, crime rates, access to electricity and sanitation, pollution levels, etc.).

The activity requires students to record living conditions for households of various income levels by investigating a set of images that depict bedrooms, kitchens, bathrooms, health/personal hygiene of household members, and the next “big thing” they plan to buy. Students then link the households’ characteristics with the data on real GDP per capita through a series of exercises in order to reveal the extent to which real GDP per capita captures the living conditions within and across countries. The proposed assignment also caters to development economics courses, where forming an accurate and palpable idea about the living conditions within and across countries represents the first step towards understanding the factors that facilitate or inhibit economic growth, thereby allowing students to think about possible policies aimed at facilitating development. The images are taken from the GapMinder Project and the Dollar Street platform were created in an effort to challenge and dismiss common misconceptions that surround global issues (e.g., the “mega-misconception that the world is divided in two,” rich versus poor, West versus the rest, developed versus developing, or North versus South. The Dollar Street features 428 households from 66 countries. Households, which are described by over 44,000 photos, are placed onto a virtual street in accordance with their monthly income level (i.e., from lowest to highest).

The paper also has all the resources required to run the Dollar Street Assignment and would be a good introductory exercise when teaching Development Economics. Furthermore it is a very good way of showing that comparisons between countries using real GDP per capita are rather simplistic and tell little about the cross-country differences in living conditions and the socio-economic realities behind the data. Below are some images from the Gapminder Project’s Dollar Street platform.

Introduction video to economic growth

Nicely put together video from the IMF that looks at a definition of economic growth and how it is measured. It explains why it matters but also discusses the limitations as a measure of standard of living in a country. Some very good graphics and ideal for those new to the subject. Useful as an introduction to ‘Growth’ in any economics course.

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Kate Raworth on ‘Rest is Politics’ Leading

In the recent Rest is Politics ‘Leading’ interview Alastair Campbell and Rory Stewart spent time interviewing Kate Raworth on their ‘Leading’ show. Kate Raworth is the author of “Doughnut Economics: Seven Ways to Think Like a 21st-Century Economist” which offers an alternative to the all too familiar policy of economic growth to solve the issues of poverty, inequality, unemployment in the global economy. Simon Kuznets, who normalised the measurement of economic growth, stated that national income cannot be a accurate measure of total welfare in an economy as it only measures annual flows of money and not stocks of wealth and their distribution. Raworth states that the current model of endless economic growth using up the finite resources of the planet is not the way forward. Most textbooks refer to the circular flow as the model of the economic system – households, firms, banks, overseas markets and the government which bears little relationship to reality today. Instead Raworth goes beyond this simple circular flow model and includes social and environmental issues – energy, the environment, raw materials, water pollution etc. The big question that is addressed in the interview is how could this work politically? Well worth listening to. Click link below:

Kate Raworth – The Rest is Politics ‘Leading’

The Doughnut
Raworth’s circular flow consists of two rings – see graphic below.

Inner Ring – this consists of the social foundation and those things we need for a good life – food, water, health, education, peace and justice etc. People living within this ring in the hole in the middle are in a state of deprivation.

Outer Ring – this consists of the earth environmental limits – climate change, ozone depletion, water pollution, loss of species etc.

The area between the two rings is the “ecologically safe and socially just space” in which humanity should strive to live. As stated in The Guardian review, the purpose of economics should be to help us enter that space and stay there. As the graphic shows we breach both rings as billions of people live below the poverty line and climate conditions, biodiversity loss, land conversion etc are at concerning levels. The video below is a useful explanation.

The 3 different waves of a business cycle.

According to Lacy Hunt, chief economist at Hoisington Investment Management the “business cycle” is actually three different waves occurring in a specific order. They peak and trough in that sequence

1. Financial cycle – lose and tight monetary policy influence the movement
2. GDP cycle – monetary policy then impact inflation and risk-taking
3. Price/labour cycle – this later makes wages and prices rise

Source: Hoisington Investment Management

Can the US Fed stimulate growth?

Although central banks can control the money supply, the velocity that it moves in an economy is very important to the business cycle – creating more money has little effect if people don’t use it. Velocity in the US is now lower than it was in the great depression. This is a serious problem for the US Federal Reserve’s attempts to stimulate growth.

There is also the problem of Marginal revenue product of debt – this is the amount of GDP growth generated by each additional dollar of debt. That has been falling for years and is set to fall even more as higher rates divert a bigger part of the revenue from debt-funded projects to interest payments instead of more productive uses.

Source: Mauldin Economics: Thoughts from the front line – 6th May 2023

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Regional GDP in New Zealand – March 2022

Stats NZ has released its Regional gross domestic product: Year ended March 2022 report, which provides a geographical breakdown of economic activity within New Zealand. New Zealand’s value-added output:

• 78% within the North Island
• 22% within the South Island

Auckland region contributing close to 38% of New Zealand’s annual GDP with Wellington coming in second at 12.5%

• Highest GDP per capita is the Wellington region $82,772 per capita, followed by the Auckland region $80,328 per capita.
• Lowest GDP per capita was the Northland region, at $46,611
• The Taranaki region recorded the highest nominal GDP per capita growth over the year (+14.3 percent), followed by the Auckland region (+11.4 percent).

A good exercise with your class is to get them to match the figures with the area of New Zealand. Figures below are in $m

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New Zealand interest rate rises an over-correction?

On my way to work last week there was a very good interview on National Radio (NZ) with Robert MacCulloch an economics professor at the University of Auckland. This ended up to be my lesson plan with my A Level class for the last day of term. MacCulloch argued that the interest rate hike of 50 basis points was too great an increase and could lead to a hard landing and deeper recession that could be avoided. His main arguments were:

• Inflation has stabilised as quarterly inflation had dropped from 2.2% to 1.4% therefore no need for a 50 basis point rise.
• In other countries (USA) inflation is dropping and those central banks are holding off on interest rate increases.
• Stated that the RBNZ wants a hard landing and therefore a recession which can be damaging with higher unemployment.
• More gradualist approach should have been adopted.
• RBNZ stated that the post-covid inflation was a temporary blip and that stagflation was back in the early 1980’s – we live in a different world today.
• Would it be better to go hard early with higher increases and then be able to loosen monetary policy? This may mean recession where you hit mortgage holders and those that become unemployed.
• A lot of other central banks adopting a wait and see approach – couldn’t the RBNZ do the same?
• Okun’s Law – A slowdown in GDP growth typically coincides with rising unemployment. A hard landing will result in this.
• In NZ GDP shrank 2% compared to the UK 11%. NZ grew in 2021 so was there a need to have close to 0% interest rates and print $50bn?

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Robots don’t necessarily mean fewer jobs but can impact inequality.

With the onslaught of COVID one wondered whether the jobs lost during the pandemic would “come back”. Part of the logic was that since robots don’t fall ill, bosses would turn to them instead of to people and COVID would act as a catalyst towards automation.

For a number of years the rhetoric has been that robots will see the end of a lot of jobs and whilst that maybe the case for some occupations the number of people in work has risen to very high levels in developed economies. For instance countries that have the highest presence of robot use e.g. Japan and South Korea also have the lowest unemployment rate. However both those countries do have ageing populations which does make the supply of labour more scarce. A study by Daisuke Adachi of Yale University suggested that between 1978 and 2017 an increase of one robot per 1,000 workers boost firms’ employment by 2.2%. Other research done in Finland concluded that the adoption of advanced technologies led to increases in hiring. According to The Economist there are an estimated 30m unfilled vacancies across the OECD.

“a strong positive association with firm survival, and that greater initial automation was associated with increases in employment”.

Automation and Inequality

However although technology doesn’t necessarily mean a loss of jobs it may have helped to increase the widening gap between incomes. In November 2021 Daron Acemoglu Testified its the US Congress on Automation and Economic Disparity. He identified two types of evidence to show the impact of technology on inequality:

1. In local labour markets (commuting zones) where there has been faster adoption of industrial robots, we see not just lower employment and wages, but also greater inequality between high-education and low-education workers and a bigger gap between those at the top and bottom of the income distribution.
2. There is an interesting relationship between two groups of workers – those that had their jobs taken over by automation and those that have not experienced much direct automation. Acemoglu’s research showed that those employed in routine tasks that can automated in industries undergoing rapid automation — have almost uniformly experienced large declines in their real wages. These groups include all demographic categories with less than a college degree. However those workers that have not experienced much direct automation, including those with post-graduate degrees and women with college degrees, have seen their earnings increase rapidly over the last 40 years. The Figure below indicates that more than half, and perhaps as much as three quarters, of the surge in wage inequality in the US is related to automation.

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Sources:

Economists are revising their views on robots and jobs. The Economist – January 22nd 2022

Daron Acemoglu – Written Testimony, House Select Committee on Economic Disparity and Fairness in Growth Hearing on Automation and Economic Disparity. November 3, 2021

Paradox of Thrift – Great Depression & GFC

Although the paradox of thrift has been a regular part of the CIE A Level syllabus it is has only become more relevant since the Global Financial Crisis (GFC). It has its origins in the 1714 book entitled ‘The Fable of Bees’ by Bernard Mandeville but it was John Maynard Keynes who really popularized this concept during the Great Depression of the 1930’s. Classical economic theory suggests that greater levels of saving will increase the amount of loanable funds in the banks and therefore reduce the cost of money – interest rates. This allows people to put off consumption to a later date thereby avoiding the risk of taking on debt and thereby give people security if their jobs became threatened during a recessionary period

Keynes’ beliefs
Keynes argues that saving was not a virtue from a macroeconomic view as he believed that negative or pessimistic expectations during the Depression would dissuade firms from investing. Cutting the rate of interest is supposed to be the escape route from economic recession: boosting the money supply, increasing demand and thus reducing unemployment. He also suggested that sometimes cutting the rate of interest, even to zero, would not help. People, banks and firms could become so risk averse that they preferred the liquidity of cash to offering credit or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policy makers. The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor.

All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Consequently, monetary policy under these circumstances is futile.

Keynes saw the 1930’s as a time when aggregate demand needed boosting – C+I+G+(X-M) – as the economy was in underemployment equilibrium. With the help of the multiplier, output and employment would increase – GDP. But with increased saving leading to reduced consumption and a fall in aggregate demand, a recession will worsen.

The fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. In the graph below, the point of equilibrium is at E where the saving curve SS and investment curve II intersect each other. The level of income at equilibrium is OY and saving and Investment are equal at OH. When the aggregate saving increases, the saving curve shifts upwards from SS to S1S1. The new equilibrium point is E1 with OY1 level of income. Saving and investment are equal at point OT. As the level of saving increases, national income decreased from OY to OY1. Similarly, the volume of saving and investment also declined from OH to OT.

Negative Multiplier

People save more → spend less → another’s reduced income → negative multiplier → reduces demand → unemployment ↑ → incomes ↓ → AD↓ therefore planned increase in savings makes a recession worse.

Paradox of thrift and the GFC

The relevance of the paradox of thrift today is different from that during the Great Depression in the 1930’s. Back then consumers weren’t in as much debt as they are today and the government played a much smaller role in the economy with little or no welfare state to provide automatic stabilizers. Also the financial system wasn’t an interconnected as it is today and the financial engineering that evolved in the 2000’s allowed for the creation of instruments that had no real value to the economy – CDO and CDS. But after the GFC the expectations of consumers became very negative and as workers became fearful of losing their jobs what followed was an increase in savings as they wanted less exposure to debt, which negatively affected consumption.

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Chinese property, the output approach and triple counting

Over the last couple of decades property has been a significant driver of Chinese growth. The dependence on real estate is shown below and it is interesting to note that China was more dependent on housing construction than Ireland and Spain prior to the Global Financial Crisis.

Real estate related activities’ share of GDP by country, 1997-2017

Source: Rogoff and Yang

Real estate has impacted consumer spending, employment of workers, investment and demand for raw materials. Investment in property has increased by 5% of GDP in 1995 to 13% in 2019 – 70% of which was residential. As for household consumption 23% is spent on real estate. How do you work out the value of output for residential investment and is there a problem with double counting?

GDP and the Output Approach

Gross domestic product (GDP) is defined as the value of output produced within the domestic boundaries of a country over a given period of time, usually a year. It includes the output of foreign owned firms that are located in that country, such as the majority of trading banks in the market. It does not include output of firms that are located abroad. There are three ways of calculating the value of GDP all of which should sum to the same amount since by identity:

NATIONAL OUTPUT = NATIONAL INCOME = NATIONAL EXPENDITURE

The output approach is the value of output produced by each of the productive sectors in the economy (primary, secondary and tertiary) using the concept of value added.

Value added is the increase in the value of a product at each successive stage of the production process. For example, if the raw materials and components used to make a car cost $16,000 and the final selling price of the car is $20,000, then the value added from the production process is $4,000. We use this approach to avoid the problems of double-counting the value of intermediate inputs. GDP will, therefore, be equal to the sum of each individual producer’s value added.

The Economist look at a simple example of calculating the output approach using a house. House is built and makes up the whole economy. It is made of steel which is made from iron ore.

House is sold – $1m
Steel is sold – $600,000
Iron ore is sold – $500,00

How significant is the construction industry? As the builders add $400,000 to the value – 40% of GDP. But if the whole economy is the house is it 100% as the iron ore is an ingredient of the steel that is bought by the builder.

The Economist mention a paper by Kenneth Rogoff and Yuanchen Yang “Has China’s Housing Production Peaked?” in which they take a different view on calculating the value of property. They use the input-output total requirement matrix with the economy divided into 17 industries – manufacture of machinery, construction, transport etc. The coefficients indicate the production required directly and indirectly in each sector when the final demand for domestic production increases by one unit. By adding up the coefficients corresponding to the construction industry they found that 1 unit of increase in the construction sector requires 2.12 units of inputs from forward (other contractors) and backward (raw materials) industries. In breaking down the construction and installation as part of Chinese real estate, investment is RMB 7,630 bn. Thus 2.12 x 7,630 = RMB 16,176 which is the total value.

Therefore in the original option the Rogoff and Yang model would include the iron ore and not the value of the house or the $400,000 value added by the construction industry. Therefore:

Steel $600,000 + Iron ore $500,00 – $1.1m

There way of removing double counting is unusual as if you add the construction output $1m, steel output $600,000 and iron ore output $500,000 there is a double and triple counting:

x2 = Steel – counted twice – purchase of steel and when house is sold
x3 = Iron ore – counted three times – purchased in raw material form, when used to produce steel and when house is sold.

The way that is normally talked about in textbooks is to only count the added value at each stage of production. Iron ore $500,000 + steel $100,000 + $400,000 construction costs – $1m = 100% of GDP in a one-house economy.

Sources:
China & World Economy / 1–31, Vol. 29, No. 1, 2021. Has China’s Housing Production Peaked? Kenneth Rogoff, Yuanchen Yang

The Economist: Free Exchange – A universe of worry. November 27th 2021

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Can globalisation help tame inflation?

Supply chain disruptions and large fiscal deficits have been part of the cause of the inflationary problems that have been prevalent in the global economy. Increased aggregate demand from government spending accompanied by supply constraints have seen prices soar. The IMF blog looked at how we should go back on history and look at how globalisation in the past has offered an antidote to inflationary spirals.

In the 1970’s technology improved global supply chains with the introduction of the shipping container which reduced transport costs of goods. Policymakers like the former US Fed Chairman Alan Greenspan see the relationship between globalisation and innovation a transition to low inflation. This idea has been embraced by current Fed Chairman Jerome Powell who talks of not only technology but demographic factors that bring about sustained disinflation. Trade liberalisation had a part of play here with the role of the General Agreement on Tariffs and Trade (GATT) – now know as the World Trade Organisation (WTO) – providing the rules for much of world trade and presided over periods that saw some of the highest growth rates in international commerce – see graph.

Modern inflation targeting by central banks (1-3% in New Zealand) also brought inflation under control as countries established a process that would allow them to attract capital flows or to globalise further. New technologies will produce better growth and increase the potential capacity of the economy (Production Possibility Curve shifts to the right) but requires a lot of cross-border co-operation. Some countries pursue costly ‘friendshoring’ strategies of steering trade to friendly nations and regimes while attempting to hobble rivals. In particular big economies look to protect strategic vital and strategic resources thereby preventing global economic growth. All of this may seem an easy solution to tame inflation but the reality is there are many variables that influence the inflation figure within countries.

Source: IMF Blog: In defense of globalisation

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