Economics in Action

Economic history is a bit of an unloved child within economics. Once at the centre of the subject it has fallen by the wayside in the rush to be scientific of recent years. Indeed most undergraduate courses no longer teach any economic history as a core subject and many don’t offer any option whatsoever. So why am I going on about economic history? Well, it turns out it’s very interesting indeed…

A Scientist for Every Issue

What sparked my interest in economic history was actually a book which had very little to do with the past. It was ‘The Cult of Statistical Significance’ by Steven Ziliak and Deirdre McCloskey.  The book was, as you have probably guessed about statistics; furthermore the authors argued that statistics was having a negative effect on the way that economists undertook research. They argued that economists liked to appear scientific and one of the ways to do so was to use statistical significance. A clean cut, simple procedure that gives a right or wrong answer appeals because it seems to offer a degree of certainty to a researcher’s findings. Does smoking lead to an increase in the use of other drugs? Do a t-test and you have your answer. However what exactly does the test of statistical significance prove? The answer, to the authors, was not much.

I am not going to talk more about this debate here (as it is quite technical, divisive and will likely bore the pants off anyone that isn’t interested in doing research in the social and natural sciences). One of the points that I did take away and thought would be interesting to talk about, was that economists can benefit from grounding their work in a wider context.

How to Build a Discipline from the Ground Up

This is where economic history can really play a part. Firstly modern neoclassical economics, the stuff that gives us supply and demand diagrams and the toolkit for how a central bank should be run, is based on a number of key assumptions about the nature of the world. Many of the debates on these assumptions happened over a hundred years ago.

Take for example the theory of value. What should the price of a good be? Should it be decided by how much of each input goes into its production?  Or should it be decided by how much use that people get out of it? Why don’t we just let the market decide and take that as its value? If the first case is true then is the value of the internet, which as a service is very cheap to provide for each user, valueless? Likewise if we use the third option and let the market decide then the internet is still pretty cheap. However, people clearly get a lot out of the internet. It has created a great deal of what economists call consumer surplus; that is what consumers get in value above and beyond the price they pay.

Trial and error, a 10000 year experiment

Secondly it allows us to enrich many of the theories we have to explain the world as it is today. I am currently reading another book (this is the last I will mention I promise!) called ‘Structure and change in economic history’ by Douglas North. In the book he attempts to create a theory which can explain why economies over time fair well and poorly.

For example, we can explain why humans moved from a hunter gatherer society to organised agriculture. For the first million and a half or so years of our history humans occupied a very small area of the globe. There was a lot of space and so as our population grew there was little pressure on hunting resources as new groups or clans could simple move into territory unoccupied by other humans. However, as the world began to be filled up the amount of free space decreased. This caused a decline in the marginal benefit of hunting as there were fewer animals to go around, and there was no incentive for tribes to not exploit all of the animals that surrounded them. If they decided to not hunt a herd or buffalo, some other tribe would. Hunting suffered from what the tragedy of the commons. At some point, the marginal productivity of hunting must have fallen below that of agriculture. When this happened it became in the interest of tribes to start farming, as extra hunters had very little effect on how much game a tribe would catch. Over time agriculture became more and more productive (from breeding crops, improving techniques etc.) and eventually replaced hunting as the main form of food production.

There are no ways of testing such a theory, but it is interesting none the less. It also demonstrates how central property rights and natural resources, two items usually omitted from modern economical analysis, can be in examining the nature of the world.

A house of cards

Unless you have been living in a hole for the last year then you have probably heard that the European financial system is in a bit of a mess. Put simply, the countries of the Euro-zone have borrowed quite a lot of money. Some of the people that governments have borrowed this money off of have become less than convinced that the euro-zone countries pay it back. As a result debt holders have been selling a lot more than buying, which has forced the price/value of these loans down and interest rates up. All-in-all, not too pretty.

The question most people are asking, is how likely is it that the cost of debt gets so high for a country (say Italy), that it will have no choice but to default on its debt. This is a very hard question to answer.

So turning to the other side of the story, what happens if a country defaults? I thought it would be interesting to take a look back at one of the more colourful periods in financial history, the Spanish Bankruptcies.

A little History

In 1492, Rodrigo de Triana became the first European to set sight on the Americas in almost 500 years. Few at the time would have thought that the sighting of land sailor on la Pinta, one of three ships in the expedition led by Christopher Columbus, would transform the shape of Europe. The ships had been sent to discover a trade route around the east of the globe to the orient. The goal was to ship spices, which were extremely valuable is Europe at the time from the east, thus making a fortune. The Portuguese would get the spice route as it later became known but the Spanish got a lot more.

It became apparent, over the next few decades that the Americas were extremely rich. Areas that now include Mexico, Peru and Bolivia had huge reserves of gold and silver. At Potosi, there was a mountain which contained the largest reserve of silver ever found. So large in fact that it is still being mined to this day. The value of gold and silver was particularly important in the 16^th century as it was literally used as currency. The influx of gold and silver made the Spanish exceedingly rich, unfortunately this didn’t last.

What would you buy with all the gold in the world?

By the time the Spanish had begun to realise the extent of their new-found wealth a new family had come to power, the Habsburgs. The Habsburgs were extremely ambitious and used their money to finance a large number of wars in order to consolidate and expand their power. They fought for control of Italy, they fought against France and later they fought against protestants in the form of the Dutch, the English and later still many Germans. They didn’t just fight. They donated huge amounts to the catholic church, building the Vatican in its current form. They even built a brand new city from the ground up, which would become their capital, Madrid.

One of the problems they faced was that while the government had a lot of money to spend, by spending it they increase the supply of money in their own lands and inevitably throughout Europe. The rate at which the money supply grew was like nothing Europe had ever seen. Not only that but it grew far faster than the Spanish economy, causing a huge amount of inflation. This impoverished the lower and middle classes and the domestic economy stagnated.

The well dries up

By 1557 Spain’s finances were extremely overstretched and the Spanish were forced to declare a state bankruptcy. This caused chaos in the European financial system of the day. It bankrupted a large part of the Fugger family which had been the Habsburgs main financiers. At the same time the Spanish crown began to borrow large amounts of money, largely from the Genoese (ironically Columbus was born in Genoa).

Continued borrowing and debt led to more bankruptcies in 1576 and in 1596. They lost the great bulk of their European possessions outside of Spain itself and the financial mismanagement in the 16^th century set the stage for the perennial decline of the Spanish Empire over the next two hundred years.

I am not saying that the west is going to go bankrupt. The two situations are not very comparable. It was fiscal mismanagement, a high growth in the money supply and overspending on foreign wars that caused the Spanish Empire to decline. It’s worth not forgetting just how bad, bad economic policies can be.

Ever wondered where all the money in the world is and where it is spent? Have a play with this amazing map to find out: http://xkcd.com/980/huge/

Here is a personal take on the situation in Iceland and the rest of Europe by our new contributor Harry Simmons:

Iceland has been the world’s whipping boy for the last few years.  The collapse of its banking system uncovered huge international systemic failures leading to the economic crisis.  The snowy nation has had a rough time of it.  But as we begin 2011, I ask the question, are they really still in that much trouble?  Figures released by the International Monetary Fund in December 2010 showed that Iceland’s GDP grew by 1.2% in the third quarter, ending the recession caused by the actions of those in its banking sector.  What about those European countries still in economic strife?

In direct contrast to the actions taken by almost all other western countries and most significantly Ireland, Iceland let its banks fail.  It was able to do so because the international risk of contagion is comparably lower than many of the European countries currently receiving bail-outs.  This forced foreign creditors and the banks themselves to foot the bill of failure, rather than the taxpayer.  Essentially, Iceland stuck to free market principles.  Those institutions that operated in an economically viable manner were able to survive; those that chose to take on too many liabilities in foreign currency must face the consequences.  In a system such as banking where when times are good, the mechanisms of capitalism and free market economics define the actions of agents in market, why should those mechanisms not also define what happens when it goes wrong?  In addition to the economic reasoning, there is also the moral issue of the taxpayer having to pay for the mistakes of a small elite.  The actions of many other governments in bailing out the banks served as an attempt to prop up an already unsustainable bubble.  These actions have exacerbated existing public finance problems further, the implications of which are to be felt by those who have not caused the problem.

During the recession Iceland’s economy shrank 11 – 15% depending on your source, but it did so with inflation peaking at 18%, which devalued its debt.  The soaring inflation was furthermore caused by the Icelandic central bank’s decision to halve the value of its currency, the Kroner.  The difference in terms of inflation between Iceland and those euro-zone countries thought to be in the worst economics position, the PIGS (Portugal, Ireland, Greece and Spain), is quite stark.  Iceland’s inflation soared whilst Ireland, for example, is still going through through a sustained period of deflation

Iceland’s inflation is now down to a respectable 3%, hence interest rates are now at 4.5% from an 18% peak.  These inflation rates are, however, higher than the PIGS.  Iceland’s debt situation is also looking up.  Forecasts for 2011 predict a deficit of 6.3% which will soon turn to surplus approaching the mid-point of the decade.  The IMF said Iceland has turned a corner and that its economic performance “compares favourably against other countries hard hit by the crisis”.

Iceland’s current account balance suffered greatly at the beginning of the crisis with the nation running a 26% of GDP trade deficit with the rest of the world, which is much greater than any of the PIGS.  However, due to the high inflation rates and devaluation of its currency, the trade deficit in 2010 fell to just 0.9% of GDP, with a surplus forecasted in 2011.  Comparably, the PIGS are still running significant deficits approaching and exceeding 10% of GDP.  The long-term effects of these deficits are yet to be seen.  One thing is clear, the PIGS do not have the monetary sovereignty of Iceland and hence cannot devalue their debt, they must in effect, toe the economic line of the European Monetary Union and European Central Bank.

Many have portrayed the path chosen by Iceland and subsequent recovery as a model for other beleaguered economies, such as the PIGS group in the EU.  However, such comparisons must be contextualised.  Iceland’s economy is comparably tiny and would have little chance of bringing the entire world economy down if it walked away from its liabilities compared to the aforementioned PIGS.  Defaulting in one of those economies would risk contagion throughout the euro zone and possibly beyond.

Iceland’s monetary independence from the European Monetary Union has been sighted by many as a possible reason for its recent good performance.  Having experienced the worst financial crisis in memory, the country has emerged ahead of many of its contemporaries having endured less punishment than many EU member states.  Greece and Ireland have already been forced to accept bail-outs, and it appears Portugal will soon follow with an €80bn rescue package mooted.

But how sustainable is this recovery?  Iceland’s public debt has reached in excess of 115% of GDP, over four times what it was in 2007.  Furthermore, Government bonds issued in foreign currency are becoming more and more expensive to repay due to the devaluation of the kroner.  Domestic austerity was aided by this devaluation and the subsequent increase in inflation; however, many commentators have indicated this had little to do with the recent return to positive growth.  The turnaround is attributed to the return to current account surplus from deficit.  Moreover, the aforementioned debt burden is not only applicable to government finance; house prices have plummeted in the crisis leaving many homeowners in negative equity.  By no means is Iceland out of the woods, its current account turnaround from deficit to surplus has been accredited to falling imports rather than a surge in exports.  More tough times are ahead.

The implications of bail-outs on the PIGS are also uncertain.  What is obvious is the political motivation behind their economic choices; the European Union needs the single currency.  It is those with vested interests in the Union that have the most to lose; there is an unnerving air of inevitability in what is happening.  Interest rates are remaining low, aimed at a sluggish Germany, whilst those euro-zone countries experiencing increasing inflation desperately need interest rates to rise.  Where the European project falls down is, in throwing hugely different nation economies under a single monetary policy, it lacked the complete supranational economic governance and social mobility required.

On balance, Iceland has taken a radical path of devaluation which saw violent shifts in economic measures, which all looked terrible whilst it was happening.  It may however appear preferable to the long-term damage that may be seen in those countries which have chosen austerity, debt deflation and bail-outs, but like driving a car using only the rear-view mirror, we will not know until it has happened.

About the author: Harry is a fist year undergraduate studying Politics and Economics (BA) at the University of Leicester.

Recently, the Centre for Economic Performance (CEP) celebrated its 21^st Birthday by holding a series of lectures at the London School of Economics and Political Science (LSE). The chief economist at the International Monetary Fund, Olivier Blanchard, gave the first lecture on the state of the world economy. Last Tuesday, the second lecture of the series was given by Professor John Van Reenen on the topic of restoring economic growth.

The Economics Network received an invitation to attend both lectures, and as a new guy on the job, I was appointed to go. However, being a second year student with a very busy schedule means I could only attend one of the lectures. Since I was doing economic growth as part of my macro course, I decided to go to the latter lecture.

I arrived in London quite late, but managed to quickly find my way to the lecture theatre in the LSE’s Old Building where the talk was held. The CEP has reserved a front row seat for me, so not only did I have the best view; I also managed to take many photos. There was a brief introduction of John Van Reenen by Stuart Corbridge before the lecture started.

John divided the lecture into three sections: the problems we currently face, the sources of growth and the policies we need. He started by saying the beginning of the current recession was a lot worse than the Great Depression; however, the government has not made the same mistakes it did in the 20s. Bank capitalisation, loose monetary policy and stimulus packages instead of spending cuts and tax raises have resulted in a much faster recovery for the UK. He also stressed that accelerated budget cuts proposed by the current coalition government will harm the economy in both short and long terms.

The three main sources of growth identified by John in his lecture were: technological innovation, management practices and microeconomic structural reforms. The main accent was made on the link between productivity and management. John argues that productivity growth is what matters, not absolute growth of GDP. Increases in productivity will drive real wages and consumption up, which in turn can
facilitate distribution. He also made a very interesting point about happiness. Current economic theory focuses on maximising income and consumption, but John thinks that after a certain level, addition to growth will not lead to more happiness. In my opinion, this is definitely something economists could focus more on.

He went on to analyse productivity in the UK. According to the findings, the UK’s relative productivity has improved compared to France and Germany. However, there is still a big gap relative to the US. John argues that this is all down to management practices. His data shows that the US has very few badly managed firms, hence, it has high productivity. On the other hand, in developing countries where there are many family businesses, management is much worse. John thinks that competition in the labour market ultimately leads to better selection of managers, which has a great impact on how firms’ productivity.

So what can we do to restore growth? The lecture concludes that structural reforms and macro policies should do the trick. Things like competition policy, public sector planning and better human capital management at the low end (apprenticeship scheme) are going to improve productivity in the long run. Finally, John argues that the austerity measures proposed by the current government will affect long-term employment as private sector cannot speedily adjust to the fiscal shock.

Here are the links to the webcasts of the two lectures if you want more:

Lecture 1: The State of The World Economy (Olivier Blanchard)

Lecture 2: Restoring Growth (John Van Reenen)

About the CEP

The CEP is an interdisciplinary research centre at the LSE Research Laboratory. It was established by the Economic and Social Research Council (ESRC) in 1990 and is now one of the leading economic research groups in Europe. Its current Director is Professor John Van Reenen.

The CEP studies the determinants of economic performance at the level of the company, the nation and the global economy by focusing on the major links between globalisation, technology and institutions (above all the educational system and the labour market) and their impact on productivity, inequality, employment, stability and wellbeing. Its researches have affected numerous Labour policies, in particular the apprenticeship scheme.

Money seems to be disappearing. The value of homes has gone down and the banks are in huge amounts of debt and have to be bailed out by the government. But where has all of the money gone?

Money consists of two main elements.

Photo by thejonoakley on Flickr

The first is cash (notes and coins). The total amount of cash in the UK is just over £50bn, with about £43bn circulating outside the banks and £7bn in banks’ safes, tills and cash machines.

But cash is a relatively small proportion of the total amount of money. So what is the rest?

Read More: Where has all the money gone? John Sloman

With food prices very much in the news, and price rises causing unrest in vulnerable countries, FT.com provides a couple of interactive guides: “The Global Food Crisis” gives an overview in the form of clickable maps, and “Why are food prices rising?” explains some of the contributing factors with video clips.

A new research report calls for longer terms of office for members of the Bank of Englands Monetary Policy Committee (MPC). Writing in the Economic Journal, Brian Henry, Mathan Satchi and David Vines argue that this would guard against the potential danger of the MPC taking too short-term a view of the economy when setting interest rates.

Much attention has been given in the press as to whether new MPC appointments are doves or hawks. But past work by Charles Bean now the Bank’s chief economist but then an LSE professor implied that, providing the Bank remains properly independent, we should not really worry. Both hawks and doves will normally make roughly the same decision and both are likely to serve society well.

The new study by Professor Vines and colleagues shows that this conclusion is only valid if policy-makers take a long-term view of the economy. Policy-makers who take a short-term view are much more likely to disagree and may not serve society well.

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The Consumer Price Index (CPI) is the wrong measure of inflation for the Bank of England to target, according to new research by Professor Simon Wren-Lewis and colleagues. Writing in the Economic Journal, they argue that the UK’s monetary policy-makers should instead focus on a measure of output price inflation that is, changes in the price of goods produced rather than goods consumed.

The study reviews two arguments for a change of focus. The first suggests that if policy follows simple rules that relate interest rates to consumer price inflation, then instability may result because of the impact of interest rates on the exchange rate.

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