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

What Did Marx Believe?

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

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

Marxist Critique of Capitalism.

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

Marx argued that Capitalism was inherently unstable because:

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

Failings of Marxism

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

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

Why Mention Marxism - Surely it is all History?

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

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

Why Marx is Important

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

Others in Great Economists Series

• Part 1 John Maynard Keynes


• Karl Marx Biography

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

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

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

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

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

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

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

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

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

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

Protectionism hurts the Developing World more than anything.

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

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

Does This Mean Free Trade is Always Good?

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

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

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

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

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

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

• Arguments against free trade
• Benefits of free trade

According the the Economist Big Mac index, the Euro is 50% overvalued compared to the US dollar on purchasing power parity. There are increasing concerns that the Euro economy is heading towards recession.

Although, the Euro economy is less affected by the global credit crunch, there are still many factors contributing to a deteriorating economy.

1. High value of Euro, making it difficult for Euro Exporters, espcially in Germany and France.
2. Housing Boom and Busts. With most attention focused on the US housing market, not many know that European house prices, in many countries have increased much more than US house prices. For example, French house prices have increased 140% since 1999 (only 80% increase in US). In Spain and Ireland, the housing bust is more pronounced leading to a loss of jobs in the construction sector. (overvalued housing markets)
   
3. Slowdown in export partners. The UK and US economies are slowing down reducing demand for Euro exports.
4. Rising Oil prices. Most euro economies are net oil importers. Rising prices are squeezing living standards and reducing spending power.
5. Inflation and Higher interest rates. Rising cost push inflation has caused the hawkish ECB to increase interest rates (currently 4.25%) this has further reduced demand and spending
6. Signs of rising unemployment and decreasing output.

Prospects for Euro

The Euro has been strengthened as investors look for an alternative to the dollar. (Dollar as reserve currency) But, with the EU economy facing recession, the Euro looks painfully overvalued. I would suggest this is a good time to sell the Euro

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

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

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

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

Keynes and Versailles Peace Treaty

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

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

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

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

see more quotes by John Maynard Keynes

Keynes and Great Depression

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

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

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

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

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

Quotes on Keynes

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

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

"We're all Keynesians now."

- US President Richard Nixon (1972)

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

- Winston Churchill

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

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

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

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

What Determines the Success of Economic Forecasts?

Current Data. Firstly, it is important to be aware of the correct current data. If we cannot be aware of how the economy is doing at the moment, it is very difficult to determine future trends. One difficult factor in predicting oil prices is that statistics on current oil stocks are hard to ascertain. For example, Saudi Arabia does not publish a full picture of its available reserves. There is much debate about the real rate of inflation see:

Looking at All Variables. It is easy for people to look at only one aspect of an issue and come to a certain conclusion based on that. For example, in 2006, the ratio of mortgage payments to income was relatively low, compared to historical trends. This meant many felt house prices were not overvalued and due to fall. However, looking at house prices to earnings painted a different picture. House price to earnings had reached an all time high making it difficult for people to afford to purchase a house; when interest rates increased, the whole picture quickly changed.

Understanding how Quickly Things Can Change. The problem with making economic forecasts is assuming that some variables will stay put. For example, the ratio of mortgage payments to income in the years 2004-06 was low, however, this was helped by record low interest rates. As soon as interest rates increased this cause the situation to change and mortgage payments rose changing the situation of the US Housing market.

The Unexpected. This is the difficult thing to include in the equation. For example, oil price rises are notoriously difficult to predict, especially when sparked by political issues. The continued rise in oil has definitely led to higher inflation than most people would have predicted 12 months ago.

Hidden Statistics. Banks and financial institutions are adept at hiding the true extent of their assets and liabilities. For example, the credit crunch took some by surprise because many were simply not aware of the risks that many subprime mortgage companies had exposed themselves to. Nor were most people aware of how mortgage debt had been sold around the global financial system. There are more than one examples, of companies who share price collapses as investors suddenly realise the true balance sheet.

Hysteresis. It is often said, that if you listen to the predictions of top economists, you would actually get a more accurate forecast by just using last years statistic. For example, if inflation was 3% last year; there's a good chance it will be close to 3% again. Of course, economic statistics change from year to year; however, it is argued that using last years figure is often more accurate than choosing a forecast from others.

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

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

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

• How Reliable are Economic forecasts?
• Economic Forecasts.org

With food prices continuing to rise, the OECD launched a report to examine why prices are rising.
One of their key findings was the increased use of crops for biofuels pushing up prices. This growth in biofuels is often promoted by government subsidies, especially in the US.

The report discounted:

• the importance of rising demand from China and India
• and the role of speculation

Report by Stefan Tangermann OECD on why food prices are rising

Related:

• The Real economic crisis - Food
• How to deal with food shortages

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

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

Keynesian view of Long Run Aggregate Supply

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

Monetarist View of Long Run Aggregate Supply


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

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

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

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

Related essays:

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

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

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

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

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

Ideology of Government Intervention

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

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

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

The US is experiencing a growing level of inequality, which is being reflected in terms of differing life expectancy, education and health standards. According to a recent report:

• US finds itself ranked 42nd in global life expectancy (despite having the richest economy and spending $5.2bn (£2.6bn) a day on health care - more than any other country in the world)
• The average life expectancy between Mississippi, in the Deep South, and Connecticut, in prosperous New England differs by 30 years.
• The average life expectancy between Asian-American and black Americans (who have the lowest), differs by 50-years.
• The US accounts for 5% of the global population, but houses 24% of the global prison population.

Causes of relative poverty in the UK include some of these reasons However, the inequality in America seems to be more deep seated. It has more sporadic public health care and welfare benefits than Western Europe.
The report raises many interesting questions:

• Why is inequality in the US so large?
• What can be done about it?
• What is the use in having the highest GDP per capita, if life expectancy is poor and inequality large?

• American inequality at Independent

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

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

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

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

Positive Aspects of The Economist

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

Negative Aspects of The Economist

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

Overall

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

• The Economist
• The Economist at Wikipedia

The Economist in The Simpsons

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

What Do You Think of the Economist?

Peak oil is the point in time when the maximum rate of global petroleum extraction is reached, after which the rate of production enters terminal decline. The Peak oil point may actually be reached earlier if supply cannot increase fast enough to meet the rising demand. The effects of the peak oil point will be rising oil prices. M. King Hubbert was one of the first to use peak oil concepts in 1956 to predict that United States oil production would peak between 1965 and 1970.

Optimists in the oil industry argue that peak oil theorists often underestimate the amount of oil reserves. Also, optimists argue that technology should advance quickly enough to create new oil fields and extract oil from currently inaccessible prices. The rise in oil prices will only serve to increase the return from investing in new technology. It is argued that the current rise in oil prices has not yet been reflected in investment decisions. There is a significant time lag between oil prices and investment; the current high oil prices should lead to a boom in oil investment in the near future.

Pessimists (or realists as they like to call themselves) argue that the tipping point has already been reached or will be very soon and the current oil price rise is merely an indicator of future rises to come. Peak oil theorists, such as Mr Simmons, argue that many future predictions of supply increases are merely wishful thinking. Evidence by EIA suggesting the oil industry is close to 99% capacity, suggests that supply is very inelastic in relation to rising prices; this only goes to show that supply constraints are already a problem.


Everyone agrees that oil has to run out sometime. The debate is when this tipping point will occur. If it occurs soon, the price rises could cause widespread economic hardship and stunt global growth. If this scenario were likely to occur, it suggests there is market failure in the development of new technologies and therefore requires government intervention to speed new technologies. If, however, oil prices will stabilise it gives credence to those who believe free markets can develop the necessary technology.

It is worth noting that in 1999, the Economist, like many other economists and oil specialists predicted that oil supplies were plentiful and 'dirt cheap' oil would continue for the foreseeable future.The longer high oil prices are sustained, the more importance people will attach to peak oil theories.

• Higher oil prices and marginal consumption
• Rising oil prices not due to speculation

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

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

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

Costs of Hyperinflation Include:

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

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

Economists are notorious for making inaccurate predictions. Many failed to predict the boom and bust in tech stocks and later the housing market. A matter of debate at the moment, is the extent to which rising oil prices are due to speculation and the extent to which they are due to supply and demand?

A recent report from the Energy Information Agency, suggests that supply and demand factors are mostly to blame. The EIA reckons that there will only be a surplus production capacity of 1.2 million barrels (nearly all this surplus is held by Saudi Arabia). This represents an industry operating at 99% capacity. When you are working so close to full capacity, and unexpected rise in demand can easily push prices higher. It is also evidence that the price rise has a fundamental reason of supply and demand behind.

Oil prices Forecasts for 2009

Lower economic growth in the US, Europe and other OECD countries could push demand lower in the coming months. However, this fall in demand is being offset by higher than expected growth in Latin America and persistently growing demand from China and India. This reflects the changing nature of the global oil industry. Oil demand is no longer so dependent on US and European demand. Demand for oil could grow despite falling demand in the US.

Economics confirm oil price rises - at Business 24/7
Why is the Price of Oil Rising?

I've selected 2 post for this week's economics blog carnival; ironically they are from different sides of the political spectrum.

Firstly, a thoughtful post at Enviro Human about the impact of $4.00 gas. Some useful points, including a mention of how many developing countries are subsidising oil. This is an interesting point and explains why demand is continuing to rise despite the rising prices. Although there is a dispute about the amount of speculation behind oil prices, the article makes interesting reading.

Interestingly, the price of petrol in the UK is about £1.20 or $2.40. As 1 US gallon = $4.00. The cost of petrol in the UK is effectively $9.08! per gallon

• Comparatively American petrol is cheap UK petrol is relatively expensive.

Related posts on Oil Prices

• Higher oil prices and marginal consumption
• How To deal with higher oil prices
• Why is the price of oil rising

Are Developers Greedy?

From the other spectrum of the political spectrum we have A post by Urbanism Legend on are developers Greedy? I don't actually agree fully with the article because I think developers ignore the impact on the environment. However, I do agree that there is a lot of NIMBY when it comes to planning. People agree the need for building more houses (in the UK anyway) but, nobody wants them built near their house. A motive is the fact that existing homeowners have an incentive to maximise the existing value of their homes by stopping new homes being built. It is a classic example of insider / outsider. The insiders here are the homeowners, the outsiders are the people wanting to buy a house in the area.

See also: Why is there a housing shortage in the UK?

If you want to submit an article to the carnival of economists you can here I'm quite selective about articles published.

Other interesting Economics links

• Recession plagued Nation demands new bubble to invest in (The Onion)

With house prices falling in the US and UK (and predicted to fall in other Developed countries) an important question is - Are falling house prices good or bad?

Reasons to Be Worried about Falling House Prices

1) Lower consumer spending

In the past, UK and US consumers have used rising equity values as a way to finance higher consumer spending. Consumers have been able to remortgage their house and spend. As house prices fall it is no longer possible to remortgage and gain equity withdrawal.

2) Lower consumer confidence.

Most consumers in the UK (75%) are homeowners; therefore, the value of houses is an important economic variable. As house prices fall, people lose confidence. Falling house prices are seen as a key barometer of the economy. If the value of their most important asset is falling, people will become more risk averse, saving more and spending less. This will cause lower consumer spending and lower economic growth. This is one of the most important factors pushing the economy into recession.

3) Construction sector

Falling house prices have led to the cancellation of many new housing projects. House building firms have seen a slump in demand and therefore, have laid off many staff. This rise in unemployment is causing further economic problems.

4) Negative Equity

Falling house prices increase the number of homeowners facing negative equity (home worth less than mortgage loan). This becomes a real problem for those at risk of defaulting. If people default they still owe money to the bank. This is bad for the homeowner and problematic for the banking sector. Negative equity will further harm the depressed balance sheets of banks. It makes banks more reluctant to lend money and may require more government backed bailouts. The more house prices fall, the greater the levels of negative equity will be. The problem is most acute in the US, where many took out 100% mortgages in the hope of rising house prices; yet, many of these new 'subprime' homeowners now face losing their home and being left with outstanding debts.

Benefits of Falling House prices

1) Correct market imbalance.

Arguably house prices became divorced from price to earnings ratios meaning that they were overvalued. Falling house prices is helping to correct this market imbalance, which had to come at some time.

2) House prices more affordable. Rising house prices led to intergenerational inequality. Many first time buyers could no longer afford to buy new homes and therefore were kept out of the property ladder. Now that prices are falling more first time buyers are able to afford a house (not withstanding the problems in getting mortgage loans)

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

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

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

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

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

What is the Solution?

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

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

This is certainly a topic which will bring a heated debate amongst economists. It is a difficult question to answer and to some extent depends upon the circumstances of the economy. These factors influence whether recessions can be avoided.

Natural Trade Cycle.

For a long time it was felt that economic growth was subject to a natural cycle of high growth (booms) followed by low growth or recession. It was felt that it was not possible for intervention to prevent these cycles. However, in recent decades, it appears that economic cycles have become less pronounced; i.e. booms less noticeable, but recessions shorter and deeper. Therefore, although it is not possible to smooth the business cycle, it is possible to minimise fluctuations so as to avoid an actual downturn. Some have credited independent Monetary policy as helping to minimise trade cycles

Global Trade Cycle

Due to forces of globalisation and the interdependence of world economies, a recession in one country often causes a recession in others. For example, a recession in the EU, would definitely affect the UK economy because the EU is our main export partner. When the world economy slows down, a recession is harder to avoid in your country. However, individual countries may do much worse or much better than the global trend. For example, in the downturns of 1981 and 1991, the recession in the UK was much deeper than the rest of the world. Whilst the government could blame some of the downturn on the world economy, the biggest factor was the individual circumstances of the UK economy.

Booms Can Be Avoided.

The best way to avoid a boom and bust, is for the government / monetary authorities to avoid a boom; if the economy expands too rapidly and inflation occurs, there comes a point when it is almost impossible to avoid a recession. If economic growth is kept close to the long run trend rate and you avoid speculative bubbles in the housing market, this is the best way to avoid a recession. If the economy is allowed to grow above the long run trend rate, then a bust becomes an almost inevitability. For a case study see: Lawson Boom and Bust of late 1980s.

Oil Shocks

Some economic factors are beyond the control of governments. A rapid rise in oil prices creates a situation of stagflation; rising inflation and falling living standards. It presents a difficult situation. The Central bank is caught between raising interest rates to control inflation and cutting interest rates to boost growth. There is a limit to what can be done, when there is a supply side shock. Whatever policy is implemented there is likely to be a worse trade off. The current oil shock makes it very difficult to avoid both inflation and recession.

Fiscal Policy

Fiscal policy is the classical response of Keynesian economics. In a recession, the aim is to boost Aggregate demand through cutting tax and increasing government spending. In theory, this injection into the economy can boost demand and stimulate the economy. To be effective expansionary fiscal policy requires:

• Low government borrowing. If you already have very high levels of government borrowing, it becomes difficult to finance further expansionary fiscal policy.
• Responsiveness of consumers. Cutting taxes may not always boost consumer spending, if people prefer to save the money. For example, high debt levels encouraged many US consumers to save their tax cut.
• Possibility of Crowding out. Higher government spending leads to lower private sector spending

Fiscal policy may not be able to avoid all recessions; but, in some circumstances can help minimise the severity of a recession. The worst thing is for a government to try and balance its budget in a recession like the UK government did in the early 1930s. See: Does Fiscal Policy solve unemployment

Monetary Policy

• Cutting interest rates should make borrowing cheaper and stimulate demand. However, lower interest rates don't always work
• If confidence is very low, people may not want to borrow, even if borrowing is cheaper. e.g. Japan had 0% interest rates in the 1990s, but, failed to stimulate the economy.
• Monetary policy can be constrained by inflationary pressures in times of cost push inflation.

I would suggest governments can cause recessions through irresponsible economic policy. I believe a good example of this is the Lawson Boom; so in a way governments can avoid recessions by not messing things up.

The US government and Federal reserve have tried hard to avoid a recession in the current climate, even at the risk of moral hazard. I believe there steps have minimised the severity of a recession; but, factors like the credit crunch and housing boom and bust are making it very difficult. This would have required a different policy several years previously. Perhaps now it is too late.

• Is UK entering into Recession?
• Problems in recovering from recession

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

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

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

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

The Problem of Complicated Pricing

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

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

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

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

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

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

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

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

Pages on cost of Posting in UK

• Postage rates UK
• Weight Comparison Guide

If you have a blog on Economics, you might like to add your best post to our forthcoming blog carnival - Carnival of the Economists. If you don't have a blog you can still suggest your favourite Economic Article.

A blog carnival is simply a way of sharing the best posts from a certain niche. I will post the carnival next Tuesday. If you would like to submit a post you can do it here - Carnival of the economists
Note: it must be on Economics and if selected we appreciate a link back to this blog.

You can also submit your favourite article from any blog, leaving a description why you think it is a good article.

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

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

Hedonics and Inflation

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

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

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

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

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

Related Posts

• The Illusion of Hedonics at Mises instituted
• problems in measuring inflation
• What is the real inflation figure in UK?
• Measuring inflation - sign of the Times

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

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

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

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

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

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

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

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

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

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

Does Anyone Benefit from A Recession?

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

Are Recessions Inevitable?

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

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

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

A recession is characterised by:

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

Related

• The effects of recession on business
• How To survive a recession
  

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

The Motor Car is Not everything.

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

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

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

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

Energy can be provided by other means

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

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

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

Reducing the Power of OPEC Countries is no Bad Thing

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

Environment

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

Related Posts

• Why is price of oil rising?
• How to deal with rising oil prices
• Should government cut tax on petrol?

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

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

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

Carlyle's view on Economics was

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

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

Dismal Science and Malthus

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

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

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

I bought a Nokia mobile phone for £20. The phone was pretty basic by current fashions; but, it does everything I wanted - i.e. it receives text messages from my students to say they can't make the lesson at 9am on a Friday morning. The phone also came with all the necessary accessories such as a mobile phone charger.

A Couple of weeks later, I've lost my phone charger, so I visit Vodaphone and buy a new charger. The thing is that the charger costs £15, only £5 less than the complete package. This is a general principle for accessories - they are relatively more expensive than buying a new phone.

Why is the Phone only a little more expensive than a Charger.

• The phone was cheap to start off with; it was an end of line product. It was probably sold at a discount to make room for new stock.
• No Choice. A phone without a charger is worthless. Therefore, as long as the charger is cheaper than a complete package, the rational consumer is forced to buy the charger. £15 is better than paying £20.
• Higher costs involved in storing chargers. Presumably Vodaphone sell a much lower % of chargers than mobile phones. Therefore, they have to keep chargers in stock for longer than phones. To make it worthwhile, they need to charge a higher price to reflect the higher cost of storing the product.
• Encourage purchase of New Phones. If you realise a charger costs £15, you may think this is probably a good time to upgrade and get a new phone. Rather than wasting £15 on getting my old model working, why not splash out and get the latest model for £50 or £60.

• Moral of the Story: Don't leave your mobile phone charger in New York. I could have had it posted on, but the cost and inconvenience would probably have been equal to £15.

Everyone seems so mesmerised by the rapid economic growth of China, it has generated a feeling of almost invulnerability about the Chinese economy. China has become the new holy grail; people talk in reverential tones about the inevitability of the China becoming the new economic superpower (if it isn't already). The talk is only of when they will become the biggest economy in the world and how this will change the global economic outlook.

However, with recent experiences fresh in the mind, economists should perhaps be more cautious when people start proclaiming the 'inevitability of growth'. The truth is that the Chinese economy faces serious signs of overheating. Could the correction be as painful as the past growth has been spectacular?

Chinese Inflation

Chinese inflation has steadily been rising (currently 8.7%) as supply constraints increase. The government are also unwilling to tackle the problem of rising inflation as they are mostly concerned about creating jobs for the unemployed. (see: Chinese inflation)

House Price Inflation.
Source: Chinese property price bubble

Even more spectacular than inflation is the growth in house prices. Especially around Beijing and the South east coast, house prices have risen at extraordinary rates. This has made capital gains for many property investors and has encouraged a wave of speculative property building. Some worry the rising prices are becoming unsustainable. But, as we all know, property prices can never fall can they?....

Undervalued Exchange Rate

Because of credit controls and low interest rates, the Chinese government has succeeded in keeping the Yuan relatively undervalued compared to its true market value. This has encouraged inflation. A low exchange rate boosts exports and increase the cost of imports. With the recent rise in commodity prices such as food, oil and energy; this is even more problematic. China is now facing both demand pull inflation (fast growth) and cost push inflation (rising prices). It is a combination leading to rising inflation and rising inflation expectations.

Despite these factors pushing up inflation, the government seem reluctant to address the problem. Real interest rates are very low; the government show an almost blindness for the damaging effects of inflation. The problem is they have got so used to magnificent growth statistics they assume that they will continue for ever. It is true to some extent that the Chinese economy is in a different situation to OECD economies; but, it is also true that if the government fails to act and rein in inflation now, the future could see a very painful correction.

Other Problems in China.

As well as the potential for boom and bust. China already has serious economic problems:

• Inequality between rural and urban; north and south
• Unemployment, especially amongst rural north
• Corruption and inefficiency of state officials.

Related

• Problems of Chinese Economy
• Chinese Economy and costs of Growth
• Graphs and Statistics for Chinese Economy
  

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

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

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

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

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

What Determines Inflation Expectations?

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

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

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

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

How Inflation Expectations Influence Inflation and Monetary Policy

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

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

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

Related Posts

• Role of Expectations in inflation
• Reasons for Low Inflation in the UK

A series of bad economic data suggests that the UK is at risk of its first recession since 1991.

The stream of bad news includes:

• Falling house prices (an important barameter of economic well being for homeowners in UK)
  
• Rising mortgage costs due to credit crunch and record low levels of mortgage approvals
• Slumping high street sales, such as Marks & Spencers.
• Falling consumer and business confidence
• Falling living standards as consumers struggle with rising food and energy prices.
• Lower growth forecasts.
• No prospect of interest rate cuts as the MPC worries over inflation exceeding target
• Rising government debt, leaving little room for expansionary fiscal policy

Further Reading

• Is UK heading towards recession?
  
• Empty Aisles except in Aldi (a cut price supermarket) at Telegraph

The International Energy Agency (IEA) argue that rising oil prices are not due to speculation, but reflect the underlying conditions of supply and demand in the oil markets.

The IEA argue that most suppliers are working flat out to increase supply, but, there has been disappointing growth in new oil fields. At the same time, the oil market has seen increased demand from emerging economies in Asia, Africa and Latin America.

They identified 6 other factors behind high oil prices

• low spare capacity within Opec;
• Political concerns over conflict in Nigeria and Iran.
• Expectations of rising prices because of peak oil theory
• Growth in demand from China, the second largest economy in the world.
• rising oil industry costs;
• tight refining capacity;
• and stockbuilding by refiners seeking to lock in profits.

The IEA also suggested that the idea of speculation was attractive because it helped provide a convenient answer for people hoping the price of oil will fall. However, if speculators are not responsible for rising oil prices, these conditions are likely to keep oil prices high for the foreseeable future. Rather than Western governments demanding action for oil prices to reduce, the solution may be to work on alternatives and reduce our dependency on oil.

Related Posts

• Why is the price of oil rising?
• How to deal with rising oil prices
• Should government cut tax on petrol?

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

1. Congestion.

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

2. Pollution

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

3. More efficient driving

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

4. More efficient Engines.

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

5. Inequality

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

6. Encourages Alternatives

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

7. Raises Revenue

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

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

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

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

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

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

10. It is necessary to switch Transport Methods

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

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

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

Related:

Why is price of oil rising?

How to deal with rising oil prices

The credit crunch which began nearly a year ago, shows no signs of abating. With declining economic fortunes in most OECD economies, there is also the prospect of things getting worse before getting better better. These are some of the problems stemming from the credit crunch

Shortage of Consumer Loans.

Banks are seeing a decline in their reserves as the they write off bad debts. Furthermore the cost of interbank lending has shot up. The result is that lending to consumers has had to fall. In the UK, mortgage approvals has fallen to the lowest levels since records began. This shortage of consumer loans is causing:

• Falling demand for houses and falling prices
• Falling consumer confidence as people struggle to be able to borrow.
• Declining profitability for banks and declining share values.
  

Tighter Credit Standards

The shortage of credit is causing banks to increase the cost of mortgage products. The gap between base rates and bank rates have increased as the banks seek to increase the profitability of their loans. The cost of arranging a fixed rate mortgage has increased significantly. The problem will be exacerbated when existing borrowers come to the end of their deal. Many homeowners who, until now, have been protected will face higher mortgage costs when they negotiate a new deal.

Mortgage Arrears Forecast to Rise.

Because mortgage costs are rising and mortgage criteria are becoming stricter, many existing homeowners face the prospect of higher mortgage costs in the future. Combined with rising energy prices and low real wage growth, there is a likelyhood of rising mortgage defaults. This is particularly a problem in the US, where rising unemployment is an additional problem. But, even in the UK, economic prospects of declined in recent months. A rise in mortgage defaults from existing levels, is the last thing that the finance system needs right now. A rise in defaults would cause further write off's leaving the balance sheets of banks looking even more dire.

See also: What Went Wrong with US economy?

It is well known that demand for oil and petrol is inelastic. Higher prices reduce demand by only a small %. The reason is that petrol consumption is a necessity for many who have to drive to work. However, just because it is inelastic doesn't mean that higher prices won't reduce demand.

Why Higher oil prices are reducing Marginal consumption.

1. Some journeys are inessential. e.g. Rather than go for a leisure drive on Sundays, you could go for a walk to the local park. Rather than drive to the supermarket you could pay for it to be delivered to your house.
2. Petrol saving tips. When petrol is cheap, people think nothing to speeding along motorways at 90mph and accelerating fast. - Time is more important than the cost of petrol. However, when the price rises 50%, the cost of petrol becomes more valuable than time saved. Therefore, people are cutting down on speeds; they are trying to drive more conservatively. There is a fascinating article here about how the UK is slowing down. Planes, trains and boats are all cutting their speeds in an effort to save fuel costs.
3. Tipping point. If petrol prices rise 5%, there is little incentive to change your behaviour. However, if they rise 50% and look like staying high, it starts to make people think about the long term. It is when this tipping point is reached that people may consider radically changing their behaviour. (see how to save petrol costs)
   

• Buying a bike
• Car sharing
• Going by Train.
• Not Buying an SUV but buying the most fuel efficient car.
• Not filling up when tank is half empty (American AA is reporting a record number of motorists running out of gas as they try avoiding filling up until next pay day)
  

It may only be a small % of car owners who make the radical change, but, it is enough to start reducing petrol consumption significantly. In the short term demand is highly inelastic, but over time demand becomes more elastic. Higher oil prices may not change the behaviour of all consumers, but, they will change the behaviour of some. The higher oil rises, the more people will consider changing their behaviour.

The interesting thing is that many of these change in behaviour have beneficial impacts for congestion, the environment and safety. Maybe higher oil prices are a blessing in disguise.

Related Posts

• Why is price of oil rising?
• How to deal with rising oil prices
• Should government cut tax on petrol?
  

Oil and The Economy

With oil and petrol prices going through the roof, these are 10 Ways to Save petrol
Nevertheless, if oil prices keep rising we may have to consider the impact of a world without oil
Rising oil prices are causing rising inflation - just at a time when Central Banks would like to be able to cut rates - The Central Bank dilemma
With Oil prices continuing to rise, a reader asks - 'Under what conditions can oil prices fall?'

Rising oil prices is not the only problem for the US. It comes at a time of record levels of debt in the US

Another problem in both US and UK is the continued decline in House Prices

Debates in Economics

• How Harmful is a trade deficit
• How To deal with Food Shortages
• The Debate on Airmiles and the environment

Understanding Economics

• Understanding Interest Rates
• Free Economic Questions and an example of price discrimination
• The Importance of Economics
• Reasons for Stock Market Volatility
• Price of Mineral Water and Beer