The Economics Book (DK) (Part 2)

Protestantism has Made Us Rich (Religion and the Economy). Recent research has reflected that Protestantism has no effect on economic growth. Protestants believe in hard work and frugality as they believe it will lead to salvation. The money earned will be reinvested in the future and grow the economy. Religion might make a difference to the wealth of nations.

The Poor are Unlucky, Not Bad (The Poverty Problem). A lot of things are out of one’s control. Such as property prices, education costs, job prospects etc. Therefore, the poor are just unlucky. The question is whether the poor should be given handouts. John Stuart Mill believed the State should intervene and help those truly in need. Amartya Sen believed that ‘poverty is about limitations in capabilities and functioning’ Extreme poverty is defined as earning less than $2 a day.

Socialism is the Abolition of Rational Economy (Central Planning). Marx believed in socialism. This means state ownership of production and limiting competition. This involved heavy central planning. Without competition, there is little information or incentive for efficient production. Therefore, this is in direct conflict with capitalism. The state decides on the prices of things. However, it is very difficult to determine this. Money is less important in Socialism. However, if you derive values of products from their labor costs. It is not the true market price. Central planning committee has to decide what goods people want so that the factories can produce them. Some argue that only the free market can provide the right incentives and information. The Socialist system in Russia collapsed.

In the socialist commonwealth, every economic change becomes an undertaking whose success can be neither appraised in advance nor later retrospectively determined. There is only groping in the dark. – Ludwig von Mises

Capitalism Destroys the Old and Creates The New (Creative Destruction). People seek new markets and new profits through innovation. This will lead to certain emerging industries and certain sunset industries. This concept was coined by Joseph Schumpeter. Entrepreneurs are the big driver of this. There are two types of technological innovations ‘Sustaining’ and ‘Disruptive’.

New products and new methods compete with the old, not on equal terms but at a decisive advantage that may mean death to the latter. – Joseph Schumpeter

War and Depressions (1929 to 1945). Economics is the ‘science of scarce resources’. After a crisis, an economic stimulus is needed. Keynes believed in government spending to get out of a recession. By controlling money supply and public spending, it was possible to kick start the economy. Economics had two branches, microeconomics and macroeconomics. After Keynes in the 1930s, people began to fall back on the free market.

Unemployment is not a Choice (Depressions and Unemployment). People used to think unemployment was a choice as people had too high wage expectations. As prices fall, value of wages rise, therefore, there is a need to retrench people. People are thus trapped in unemployment and firms are under producing. In 1936, Keynes published his most important work. In modern times, unemployment remains a problem. Unemployment is not just a problem with individuals. It is a problem with the economy. This is known as ‘involuntary unemployment’. Even a free market will not return the market to equilibrium easily. One way to solve unemployment is to force people to take a pay cut. However, not many in reality will accept this. This is not a realistic solution. He believed in fiscal stimulus and it doesn’t matter how. The ISLM model is very popular nowadays. Many people don’t want their wage to fall as they are constantly comparing themselves with their peers.

The sooner involuntary unemployment is disposed with, the better. – Robert Lucas

The treasury could fill old bottles with banknotes and bury them…and leave it to private enterprises on well-tried principles of laissez-faire to dig the notes up again. – John Maynard Keynes

The difficulty lies not in the new ideas but in escaping from the old ones. – John Maynard Keynes

Some People Love Risk, Other Avoid It (Risk and Uncertainty). People don’t just make decisions on probability. Risk averse people tend to have lower returns and risk seeking people tend to have higher returns. In order to attract people to take on risk, you need to provide higher returns. Risk is different from uncertainty. Uncertainty is when you don’t know the outcomes.

Profit arises out of the inherent, absolute unpredictability of things. – Frank Knight

Government Spending Boosts the Economy by More than What is Spent (The Keynesian Multiplier). Government Spending will create employment. The workers will then spend more, creating even more employment. Keynes was a strong advocate of government spending. A standard estimate is that every $1 of government spending might create an increase in income of $1.40 through these secondary effects. ISLM (Investment, Savings, the demand for Liquidity, and the Money Supply).

Besides the primary employment created by the initial public works expenditures, there would be additional indirect employment. – Don Patinkin

Economies are Embedded in Culture (Economics and Tradition). It is a common belief that people are rational. However, Karl Polanyi countered this why saying is that culture drives economic life. People desire status in society and therefore work hard in getting there. An example of his theory in action is in the Trobriand Island tribe. He didn’t believe that markets and social structures could exist harmoniously.

The economic system is, in effect, a mere function of social organization. – Karl Polanyi

Managers go for Perks, Not Their Firm’s Profits (Corporate Governance). Not all companies are run in the best interests of their shareholders. Nowadays, management have a huge say in how a company is run. Also, the problem stems from passive shareholders. Berle and Gardiner founded the modern corporate governance. This is to ensure that management acts in the interest of shareholders. However, in the 2008 financial crisis, corporate governance failed.

The Economy is a Predictable Machine (Testing Economic Theories). Econometrics is the testing of economic variables through mathematical means. However, past performance is no guarantee for future performance. There are many variables to consider.

Intermediate between mathematics, statistics, and economics we find a new discipline which…may be called econometrics. – Ragnar Frisch

Economics is the Science of Scarce Resources (Definitions of Economics). Scarcity forces economic choices. ‘Science of human actions in the face of limited resources with multiple uses.’ ‘Human needs are infinite, yet there are only a finite amount of resources.’ This definition has been wider accepted.

We Wish to Preserve a Free Society (Economic Liberalism). Prices should reflect total market information and governments should aim to protect that. Friedrich Hayek was a very influential economist. He didn’t governments had the ability to shape society. He was right when those states with planned economies would head to a totalitarian state. Some economists defended Socialism. Hayek argued that all individuals were very sure of what they were doing and market had imperfections. He believed in the free market. The government should intervene only to restore the market to its free market state. Therefore, the state should only have a limited role.

The more the state ‘plans’, the more difficult planning becomes for the individual. – Friedrich Hayek

Industrialization Creates Sustained Growth (The Emergence of Modern Economies). More people work in cities, obtaining a higher level of skill and education. This leads to cultural change and business growth. Future generations will also enjoy this. Simon Kuznets created this idea. He saw that factories will take over farms one day. Industrial Revolution helped Britain in the 18th Century. In modern society, there is now a move to the service sector.

Different Prices to Different People (Price Discrimination). Price discrimination is possible even in markets with only a few firms. Firms want to charge according to how much each customer is willing to pay. There are generally three types of pricing models. The first to charge each customer the maximum he/she is willing to pay. The second is to reduce the price for each additional unit sold. The last is to identify different customer groups and charge each group accordingly. This might allow people like students to benefit as they can now afford to watch a movie.

Price discrimination is the act of selling the same article produced under single control at a different prices to the different buyers. – Joan Robinson

Post War Economics (1945 to 1970). It was a difficult time for economies to rebuild. The UN was formed in 1945. Keynes was lauded for his emphasis on fiscal policy when there is an economic crisis. However, Asia and Russia did not fair so well. The impossibility theorem shows that there is no perfect voting system. Perhaps a country’s growth can be measured by other factors.

In the Wake of War and Depression, Nations Must Cooperate (International Trade and Bretton Woods). Gold initially backed paper money. After the Great Depression, many tried to devalue their currency, making exports more attractive. Restrictions on trade only help to prolong the Depression. In 1944, delegates agreed to peg currency against USD. This was governed by the IMF, where they could distribute emergency funds. In 1971, President Nixon suspended the dollar-gold link (Bretton Woods system). There is a need for nations to cooperate and open trading doors to others in times of crisis.

All Poor Countries Need Is a Big Push (Development Economics). Poor countries require investments in infrastructure and industry simultaneously. Only governments can afford to do this, not corporations. Poor countries need a big push. Massive capital injections are necessary. Infrastructure and Factories are 1 set. You need both for the economy to start going. Many industries are linked to another. When one does well, the other might or might not do well also. Thus, it is possible to go from nothing to everything. It is hard for private enterprises to drive this. Governments need good knowledge of the forward/backward industries. A good state should not allow too much government intervention. The UN offers aid to developing countries.

Most industries catering for mass consumption are complementary in the sense that they provide a market for, and thus support, each other. – Ragnar Nurkse

People are influenced by Irrelevant Alternatives (Irrational Decision-Making). In theory, people make decisions based on probability. However, research has proven that people switch irrationally to other products. Maurice Allais didn’t believe people sought the greatest utility as this is based on assumption and choices are often co-related. ‘The violation of independence takes place in situations of uncertainty.’ People often violate the independence axiom. People generally like alternatives.

Governments Should Do Nothing but Control the Money Supply (Monetarist Policy). Keynes didn’t believe in controlling the money supply. However, Milton Friedman believed that controlling the money supply will work. Money will affect output in the short run and prices in the long run. The failure for people to spend in a recession prolongs it. The problem of state intervention to reduce unemployment led to high inflation. He claims that fiscal stimulus causes inflation and should be avoided. ‘Money should grow at a modest, constant rate in order to keep inflation low.’ He believed in the short run that output will increase in the short run and in the long run prices will increase. Inflation and unemployment is governed along the Philips Curve. There is such a trade-off. However, there is a natural rate of unemployment. Some argue that people e predict government’s plans and therefore in the short run, the Philips Curve is vertical. It is possible for both unemployment and inflation to increase together. This is known as stagflation. Nowadays, monetary supply is controlled, as is fiscal policy. In the 1990s, countries used exchange rate or change interest rates to impact inflation.

The More People in Work, The Higher their Bills (Inflation and Unemployment). There was research that reflected periods of high inflation coincided with low unemployment. Governments could pick their point on the Philips Curve. However, in the 1970s, both unemployment and inflation moved together. The Philips Curve did not take into account people’s expectations of inflation. According to him, there is no trade off. There is only a natural rate of unemployment in every economy.

People Smooth Consumption Over their Life Spans (Saving to Spend). People save money and take into account their lifetime income when spending. When government spending increases, people’s spending increases by a multiplier of that. However, in reality, ‘the ratio between household consumption and income over the long run turned out to be stable.’ Individuals anticipated how much people they needed in the future and started to save. People save when they are young, spend when they are old. This is the life-cycle hypothesis.

‘Permanent income hypothesis’. ‘Successive generations seem to be less and less thrifty. – Franco Modigliani

Institutions Matter (Institutions in Economics). Some economists investigate the role of institutions in the State. They are important as they set the laws, customs and traditions of a society. People tend to follow them. Tension is rooted in colonial origins. When institutions degenerate, problems start for the economy.

People Will Shirk If They Can (Market Information and Incentives). Banking bailouts are moral hazards. When no one is watching, people put in less effort. This is because actions are hidden from the other party. This is known as ‘moral hazard’. Principal can’t monitor the agent all the time. Wording the contract in a certain way might prevent this from happening. Banks who think they are too big to fail might keep thinking that the government will bail them out. This causes them to take on excessive risk.

Theories about Market Efficiency Require Many Assumptions (Markets and Social Outcomes). Market efficiency requires assumptions that price completely reflect customer preferences etc. Walras believed that markets, without intervention, can reach a stable equilibrium. Only under certain conditions could a set of markets remain in equilibrium. The first welfare theorem states that ‘any pure free-market economy in equilibrium is necessary ‘Pareto efficient’. The second welfare theorem states that ‘any of these Pareto- efficient distributions can be achieved using free markets.’ Using a Contract Curve. For the theories to hold, people need to rational and respond to market signals. There cannot be externalities or economics of scale.

An allocation of resources could be efficient in a Pareto sense and yet yield enormous riches to some and dire poverty to others. – Kenneth Arrow

There is no Perfect Voting System (Social Choice Theory). To evaluate the well-being of a society, values of individual members need to be taken into account. There must exist a system for them to state their preferences. ‘It is impossible to devise a voting system that truly reflects the preferences of an electorate’. Some prefer A to B, and B to C, but also C to A. With an ideal voting system, it is not possible to satisfy all the assumptions, one being that there should be no dictator. Arrow’s theorem is now being widely applied in society.

The Aim is to Maximize Happiness, Not Income (The Economics of Happiness). Joblessness is a main course of unhappiness. In the 1930s, GDP calculations came about. Rising GDP meant increasing wages and jobs, falling GDP means unemployment. However, there is little correlation between GDP and real social welfare. High GDP could lead to widening income disparity. People in richest countries need not seem the happiest. The concept of the ‘hedonic treadmill’ was introduced. ‘Keeping up with the neighbours’. In modern times, different indicators have emerged.

Economic things matter only in so far as they make people happier. – Andrew Oswald

Policies to Correct Markets Can Make Things Worse (The Theory of the Second Best). The real market consists of many distortions which are linked. Correcting one might worsen others. Governments need to act with caution. In some cases, there are no best solutions and distortions can be permanent, thus one has to rely on second best solutions. Sometimes, it is better to leave an imperfection alone rather than interfering.

Make Markets Fair (The Social Market Economy). The Social market was perceived to be fair as it ensured the equal distribution of wealth. Armack believed in the government playing a minimal in the economy. Industry will remain in private ownership but the government will provide several public goods, including pension and taking care of unemployment. Many of the European countries thrived under the social market system. China’s economy is now a ‘socialist market economy with Chinese characteristics’.

Over Time, all Countries Will be Rich (Economic Growth Theories). Poor countries can reinvest their capital into machinery/infrastructure that can increase output to a larger extent than rich countries. This is known as convergence, over time all countries will be rich. This is basically poor countries can grow quickly and catch up. However, Solow’s theory does not hold true in reality. There is little evidence supporting Solow’s theory.

Globalization is not Inevitable (Market Integration). It is the integration of markets. Government’s policies can hinder market integration (fusing many into one). Price differences between different countries are eliminated. Easier transportation contributed to this. Most tariffs have been scrapped. Institutional rules also hinder markets. Dani Rodrik was against ‘deep integration’. Market integration, democracy, and sovereign nation states cannot co-exist. Only two out of the 3 can co-exist. There would be no sovereign nation states should the institutions have to change. Democracy will be affected as well. In modern times, countries avoid deep integration and still keep their institutional rules. Globalization is not all good as well.

Socialism Leads to Empty Shops (Shortages in Planned Economies). The state protects shops from bankruptcy. Therefore, firms do not bother about costs. Therefore, ‘Socialism leads to empty shops.’ Planned economies could not produce enough at the correct quantity. Concept of ‘soft budget constraints’ and ‘hard budget constraints’. Firms had little incentive to supply goods and services efficiently. Kornal argued that the ‘soft budget constraint’ was a feature of the planned economy. Even the major European and US banks were in the ‘soft budget constraint’ category as they feel that they can be bailed out. Even in a free market economy, there are both ‘soft budget constraints’ and ‘hard budget constraints’.

What Does the Other Man Think I Am Going To Do? (Game Theory). ‘Minimax rule’ is to minimize the maximum loss on any turn. Cournot, in 1938, started analyzing the issue of game theory. Game theory is the strategy in which people behave in every situation. People sometimes have to make independent decisions in non-cooperative situations. People will select their best strategy based on the fact that opponents are also selecting their best strategy. ‘Each player’s strategy is optimal against those of the others.’ This is the Nash equilibrium. However, when this strategy is employed, it is often not the optimal result for the group. Therefore, it is better to co-operate. People suffer from bounded rationality.

You know what you are thinking, but you do not know why you are thinking it. – Reinhard Selten

Rich Countries Impoverish the Poor (Dependency Theory). Rich countries exploit free trade by trading with poor countries on terms that favor them. The rich get richer, the poor get poorer. This is known as the ‘dependency theory’. The rich set their own terms and make it favorable for themselves. However, some developing countries isolate themselves and instead, choose to trade among other developing countries.

You Can’t Fool the People (Rational Expectations). Keynes model fails to take into account people’s expectations. Fiscal policies only work in the short run. People anticipate effects of government fiscal policy. They will predict future prices based on an economic, rational model in their heads. Government can take people by surprise in the short run. Under rational expectations, ‘Unemployment is determined by the productive capacities of the economy: the productivity and technological capacities of its firms and the efficiency of its markets. Policy makers cannot boost the economy beyond this level of employment.’ Lucas believed in modelling based on people’s preferences.

People Don’t Care About Probability When They Choose. Humans seek to boost their expected utility. However, people tend to ignore probabilities. People prefer the ‘known unknowns’ to the ‘unknown unknowns’. They show a preference for known odds. ‘People want to know more about the unknown, unquantifiable risks that expected utility cannot account for.’

Similar Economies Can Benefit From a Single Currency (Exchange Rates and Currencies). Some believe in the free floating exchange rate. After WWII, the Bretton Woods system was based on a fixed exchange rate system. However, this led to a balance of payment system (between imports and exports). In Europe, they adopted the floating exchange rate system. If countries are of similar size and growth, they can choose to adopt the same currency as it will eliminate foreign exchange gain/losses. It is not realistic to have a global currency as well. A country with its own currency can control money supply and interest rates. The Euro was an example of a common currency. However, there was certain criteria for countries to meet before they could enter the EU. ‘National debt cannot exceed 60% of GDP and annual deficit cannot exceed 3% of GDP.’ The ECB is now the common central bank. However, risk sharing through transfer of tax revenues did not occur. Individual countries could still set their spending and tax levels. Within the Euro area, massive differences emerged. Some countries had huge deficits, while some had huge surpluses. This led to a few nations requiring bailout, including Greece. There is debate whether a common currency is the best thing for the Eurozone. Even fiscal transfers need political consensus.

Famine Can Happen in Good Harvests (Entitlement Theory). Famine can occur even there is a surplus of food, especially when wages have plunged. The way food is distributed also causes a problem. ‘It is far more common for food supplies to be unavailable to those who need them the most.’ Food price rising also is a major issue that needs to be addressed. Amartya Sen is a major contributor in this field

Contemporary Economics (1970 to present). Friedman opposed Keynesian ideas and believed in controlling inflation. He also believed in the free market. This marked the period of the deregulation of financial institutions. Liberalization of markets. Capitalism did not fair well during the crisis and some were even starting to believe in Marxism. The Laffer Curve.

It is Possible to Invest Without Risk (Financial Engineering). VAR was introduced, so was CAPM. Countries were experiencing inflation in the 1970s and the US experienced trade deficits. Restrictions on the CME was lifted in 1972. Forward and futures contracts emerged. Derivatives were invented to hedge positions. It also provides high leverage. Derivatives contracts were soon traded on the exchange. Cash settled derivatives were very risky, as there was no need to exchange the underlying. It was hard to price derivatives until the Black-Scholes model emerged. There should be a no arbitrage rule. In 2008, the financial markets collapsed in spectacular fashion.



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