Aristotle was right: Disappearing middle class = Increasing inequality = Disappearing democracy.

Around the globe the size of the middle class is diminishing and with it societies are becoming more unequal. The Greek philosopher, Aristotle, 2,400 years ago summarising his analysis of the Greek city states pointed out that democracy depended on the size of a country’s middle class. With a proportionately bigger middle class a democracy tends to work well as it promotes social mobility, encourages aggregate demand which in turn leads to economic growth. Notice in the graph below how the Scandinavian countries have higher social mobility compared to the other extreme of the US and the UK.

Source: FT – How to reform today’s rigged capitalism

Aristotle warned that when inequality – see graph below – reaches a certain point it becomes very damaging to society. He refers to the importance of the middle class in his book Politics:

The best constitution is one controlled by a numerous middle class which stands between the rich and the poor. For those who possess the goods of fortune in moderation find it “easiest to obey the rule of reason” (Politics IV.11.1295b4–6). They are accordingly less apt than the rich or poor to act unjustly toward their fellow citizens.

A constitution based on the middle class is the mean between the extremes of oligarchy (rule by the rich) and democracy (rule by the poor). “That the middle [constitution] is best is evident, for it is the freest from faction: where the middle class is numerous, there least occur factions and divisions among citizens” (IV.11.1296a7–9). The middle constitution is therefore both more stable and more just than oligarchy and democracy.

“The best political community is formed by citizens of the middle class, and that those states are likely to be well-administered in which the middle class is large, and stronger if possible than both the other classes . . . ; for the addition of the middle class turns the scale, and prevents either of the extremes from being dominant.”

Source: Why Inequality Matters – Aristotle and the Middle Class

Source: FT – How to reform today’s rigged capitalism

Heather Boushey in her book ‘Unbound’ argues that inequality subverts growth and democracy in three ways:

  • Inequality creates barriers to the supply of talent, innovation and finance as wealthy families monopolise educational and workplace opportunities. This is done by the cost of education and the influence of social networks.
  • It overturns private competition and public investment as powerful corporations force out competitors and suppress wages. Also the government underfund public goods which are essential for social mobility.
  • Lower wages reduce consumer demand and lead to less buying power which in turn encourages more borrowing and pushes the economy toward financial instability.

Paul Volcker – 1929-2019 – the slayer of inflation.

I first came across Paul Volcker in the ‘Commanding Heights’ series produced by PBS. Appointed to the position of Chairman of the US Federal Reserve in 1979 by the then President Jimmy Carter, Paul Volcker understood the problems of the Great Inflation in the US economy which was at around 11.5%. Up to this point Carter had attempted to follow Keynes’s formula to spend his way out of trouble by dropping taxes and increasing government spending. However this was not working. Below is an extract from the PBS series.

It came to be considered part of Keynesian doctrine that a little bit of inflation is a good thing. And of course what happens then, you get a little bit of inflation, then you need a little more, because it peps up the economy. People get used to it, and it loses its effectiveness. Like an antibiotic, you need a new one; you need a new one. Well, I certainly thought that inflation was a dragon that was eating at our innards, so the need was to slay that dragon. Paul Volcker

Volcker’s policy to tighten the money supply with increasing interest rates, which peaked at 21.5% but was not popular with Jimmy Carter who lost the election to Ronald Reagan. But in order to get prices down the economy had to experience a recession and the longer the inflation was out of control the worse the recession would be. Unemployment did hit 10% but could have been much worse. As Ronald Reagan said referring to a recession – ‘if not now when? If not us who?’

He saw the primary focus of central banker was to control inflation and preserve the value of money whether is be keeping prices stable or ensuring that there is not easy access to credit. Below is a tribute from Paul Solman of PBS.

A2 Economics – Labour Market – MRPL

Marginal Revenue Product refers to the amount of revenue generated by an additional worker. This is a theory of wages where workers are paid the value of their marginal revenue product to the firm and is based on the assumption of a perfectly competitive labour market. Therefore an employer will hire workers up to the point where the value of the marginal product of labour equals the wage that is being paid. The demand curve for labour can therefore be represented by the value of the marginal product curve – see graph below and a revision mindmap.

Adapted from: AS and A Level Economics Revision by Susan Grant

Mozambique’s monopsony market goes nuts

The primary sector is seen as integral to assisting developing countries grow and raise their standard of living. For the Mozambican economy the cashew industry is an example of this – more than 40% of Mozambican farmers grow and sell cashew, and the processing sector provides formal employment to more than 8,000 individuals. Mozambique is currently the second largest producer in East and Southern Africa and has links with premium export markets, including the United States and Europe.

In the 1960’s the cashew nut industry in Mozambique was in good shape supplying over 50% of global supply and processed most of these domestically and thereby adding employment. However, with a civil war and the instruction from the World Bank in the 1990’s to remove controls and cut taxes on the exports of raw nuts, trading firms shipped out cashews and processed them overseas with significant job losses. But an about turn by the government in 2001 has seen:

  • an export tax of 18-22% for raw nuts
  • a 0% tax for processed kernels.
  • a ban on exports during the first few months of the harvest

16 factories employing 17,000 people, which process about half the cashews sold.

However by having less competition amongst processors – a little like a monopsony market – farmers selling raw cashew nuts are finding that the price of their crop is being reduced by the smaller number of processors. Most cashew nut farmers are smallholders and the government seems to be oblivious to the 1.3m families for the sake of protecting processing jobs.

Monopsony – one buyer many sellers – other examples include:
– large supermarkets, who can dictate terms to smaller suppliers.
– buyers of labour in the labour market.

There is a dilemma for developing countries as when a primary industry starts to expand into the secondary stage of processing, government protection can hurt nut-growers. Just like the coffee industry farmers are at the mercy of a small number of middlemen in this case the processors monopsony power.

Source: Mozambique’s nut factories have made a cracking comeback –
The Economist 12th September 2019

Climate change = higher interest rates for developing countries

A significant number of developing countries are located in and around the equator which also means that they are more exposed to the extremes of climate change. As the world gets hotter these countries will suffer the most which makes their ability to advance their standard of living even harder. Temperatures in tropical climates will become far more variable and soil near the equator will dry up reducing its ability to dampen temperature swings e.g. Amazon rainforest, Congo, Indonesia etc.

The additional cost to poor countries in avoiding the damage caused by climate change is estimated to be between US$140bn – US$300bn each year on measures such as costal defences, strengthening buildings etc. This is according to the UN Environment Programme which assumes that global temperatures will be only 2°C above pre-industrial levels by the end of the century – unlikely according to The Economist. Not only are these countries suffering from climate change‑related drought, which will lead to a consequent drop in agricultural production and rise in food insecurity, but it also means higher interest payments than similar countries that are less exposed to climate change.

Climate Change = Higher risk of default = Higher Interest Payments

The V20 countries
The Vulnerable Twenty (V20) Group of Ministers of Finance of the Climate Vulnerable Forum is a dedicated cooperation initiative of economies systemically vulnerable to climate change. The call to create the V20 originated from the Climate Vulnerable Forum’s Costa Rica Action Plan (2013-2015) in a major effort to strengthen economic and financial responses to climate change. Originally 20 countries it has now expanded to 48 and the membership is mostly from poor countries that make up less than 5% of global GDP. They include the following:

Afghanistan, Bangladesh, Barbados, Bhutan, Burkina Faso, Cambodia, Colombia, Comoros, Costa Rica, Democratic Republic of the Congo, Dominican Republic, Ethiopia, Fiji, The Gambia, Ghana, Grenada, Guatemala, Haïti, Honduras, Kenya, Kiribati, Lebanon, Madagascar, Malawi, Maldives, Marshall Islands, Mongolia, Morocco, Nepal, Niger, Palau, Palestine, Papua New Guinea, Philippines, Rwanda, Saint Lucia, Samoa, Senegal, South Sudan, Sri Lanka, Sudan, Tanzania, Timor-Leste, Tunisia, Tuvalu, Vanuatu, Viet Nam and Yemen.

Research has estimated that V20 countries pay 1.2% higher than comparable countries which raises the V20’s borrowing costs by about 10% which is equivalent to an extra US$4bn each year in interest payments. It has also been estimated that of corporate debt a significant amount is held by countries who are the most at risk of climate change. This equates to 3% of total debt in more than 60,000 firms in 80 countries. These high risk countries were charged 0.83% higher interest on loans which equates to roughly a 10% premium. Therefore credit rating agencies are including climate change in their risk models and what makes it worse for developing countries is that they tend to be primary based economies which are the most susceptible to climate change. Moody’s, the credit rating agency, has suggested that of the 37 countries that are most vulnerable, farming accounts for 44% of employment on average.

For developing countries to counter the impacts of climate change sovereign parametric insurance has been prevalent. This insurance is pooled amongst countries in close proximity and makes the premium more affordable. This insurance relies on risk modeling rather than on-the-ground damage assessments to estimate the cost of disasters. Parametric insurance policies pay out automatically when certain pre-agreed conditions, such as wind speed, rainfall or modeled economic losses, meet or exceed a given threshold. Examples of areas where countries have pooled insurance are:

  • Caribbean Catastrophe Risk Insurance Facility
  • African Risk Capacity
  • Pacific Catastrophe Risk Insurance Company
  • Southeast Asia Disaster Risk Insurance Facility – under development

Like any insurance although it might be under used it does mean that countries can access money to recover and rebuild their economies – ideally with greater resilience.

Source: The Economist – ‘Costing the earth’ – 17th August 2019

Automatic stabilisers – Direct Stimulus Payments

It is unavoidable that recessions are part of the economic environment that we live in. In tackling the impact of recessions it has become apparent that one cannot solely rely on expansionary monetary policy of the central bank. Economic conditions have changed, as if an economy was to fall into recession in this low interest environment monetary policy options are far more limited than they were post the GFC. Add to this a higher debt level and you put further pressure on the banking system. A publication this year entitled “Recession Ready – Fiscal policies to stabilise the American economy.” (Published by the Hamilton Group – Washington Center for Equitable Growth) suggests that governments should assist in ensuring that the recovery phase is much quicker than it has been by ensuring confidence amongst businesses and households so they resume investing and spending again. They focus on antirecession programmes known as “automatic stabilisers.”

Automatic stabilisers are the automatic increases in revenues and decreases in expenditure in the government budget that occur when the economy strengthens, and the opposite changes that occur when the economy weakens.

Increase in GDP growth = the government will receive more tax revenues – people earn more and so pay more income tax. As it is assumed that unemployment decreases the amount of money spent on unemployment benefit decreases.

Reduction in GDP growth = lower incomes – people pay less tax. As unemployment increases the government spends more on unemployment benefits. This increase in benefit spending and lower tax collection helps to limit the fall in aggregate demand.

One of the chapters written by Claudia Sahm proposes a direct payment to individuals that would automatically be paid out early in a recession and then continue annually when the recession is severe. During a recession consumer spending (C) declines sharply – see graph – and as it makes up above 70% of most countries aggregate demand – C+I+G+(X-M) – this can lead to employment losses and reduced output. Consumers therefore are integral to boosting aggregate demand and direct stimulus payments to individuals should become part of the system of automatic stabilisers as additional income translates quickly into additional spending.

Trigger to start automatic stimulus payments.

The idea behind this is for direct payments to individuals after a 0.5% in the quarterly unemployment rate. If you look at each recession since 1970 the stimulus trigger of an increase in 0.5% unemployment meant that payments would have been triggered within three months of the start of the past six recessions (USA). But there are some concerns with using unemployment data:

  1. Unemployment rate tends to lag the business cycle as unemployment tends to peak after the recession ahas ended.
  2. The rise in unemployment doesn’t necessarily mean you are in recession – two consecutive quarters of negative GDP.

Lump sum v Tax cuts

There is an argument that a one-off lump sum payment is much effective in boosting spending than changes in income tax which would be spread fiscal stimulus throughout the year. Even if the Marginal Propensity to Consume (MPC) was the same for both lump sum and tax cuts it would not be until early in the next year that the full spending occurred under the tax cut option. The delay in spending from lump sum payments would be three months thus the overall stimulus boost would be both larger and more rapid – see graph below.

Final thought
Direct stimulus payments would quickly deliver extra income to millions of households at the start of a recession and maintain income support until the recession has subsided. This should generate more aggregate demand and thereby reducing the impact of the recessionary phase.

Source: “Recession Ready – Fiscal policies to stabilise the American economy.” (Published by the Hamilton Group – Washington Center for Equitable Growth)

A2 Economics – The Accelerator

This part of the syllabus will come up either as a multiple-choice question or part of an essay. 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 CIE AS and A Level Economics Revision Guide by Susan Grant

US China Trade War – end in sight?

From The Economist YouTube channel – a good overview of the US China Trade War. After joining the WTO, China became an economic superpower. But people had expected the country to also become more like a Western capitalist economy. That didn’t happen. America now claims that China achieved its growth by not playing fair. Are those claims justified?

The Trump administration has been using tariffs or taxes on imported goods to try to force the Chinese to change their ways. In July 2018 America imposed tariffs of 25% on $34bn worth of Chinese products. That almost doubled the average tariff rate on Chinese imports from 3.8% to 6.7%. And it’s American firms that have to pay that tax. But with every increase from America, came an increase from China. Since the start of the trade war China has more than doubled its average tariff rate. America’s has tripled. The fight has become overtly political because China’s tariffs are hitting President Trump’s voter base. Many counties where Trump won in the 2016 election were here in the Great Plains and these are the counties most affected by China’s tariffs.

A2 Revision – Liquidity Preference

With the A2 multiple choice tomorrow here is a mind map on liquidity preference. The liquidity preference or the demand for money is the sum of the transactionary, precautionary and speculative demand for money. Only the speculative demand is inversely related to interest rates. It is the speculative demand that students find difficult to understand. This is money not held for transaction purposes but in place of other financial assets, usually because they are expected to fall in price.  Demand is interest elastic – i.e. is affected by changes in interest rates. Below is a mind map and some notes.

Adapted from CIE AS A Level Revision Guide by Susan Grant

Bond prices and interest rates are inversely related – Interest Rates ↑ = Bond Prices ↓ and Interest Rates ↓ = Bond Prices ↑. If a bond has a fixed return, e.g. $10 a year. If the price of a bond is $100 this represents a 10% return. If the price of the bond is $50 this represents a 20% return, i.e. the lower the price of the bond, the greater the return.

At high rates of interest, individuals expect interest rates to fall and bond prices to rise. To benefit from the rise in bond prices individuals use their speculative balances to buy bonds. Thus when interest rates are high speculative money balances are low.

At low rates of interest, individuals expect interest rates to rise and bond prices to fall. To avoid the capital loses associated with a fall in the price of bonds individuals will sell their bonds and add to their speculative cash balances. Thus, when interest rates are low speculative money balances will be high.

AS Revision – Indirect Tax

The AS multiple-choice paper is coming up and here is this graphic to explain indirect taxes – a popular question. An indirect tax will have the following effects on the market:

Indirect Tax

• The supply curve shifts vertically upwards(effectively a shift to the left) by the amount of the tax(gf) per unit. The price increases but not by the full amount of the tax. This is because of the slopes of the demand and supply curves.
• The consumer surplus is reduced from acp to agb. The portion gbhp of the old consumer surplus is transferred to government in the form of tax.
• The producer surplus is reduced from pce to fde. The portion phdf of the old producer surplus is transferred to the government in the form of tax.
• The market is no longer able to reach equilibrium, and there is a loss of allocative efficiency resulting in the deadweight lost shown by the area bcd. This represents a loss of both consumer surplus bhc and the producer surplus hcd that is removed from the market. The deadweight loss also represents a loss of welfare to an individual or group where that loss is not offset by a welfare gain to some other individual or group.