Recent news articles on the economy have worried aloud of falling prices leading to a "deflationary spiral." The current economic malaise in Japan, as well as the Great Depression are sometimes cited as examples of such a spiral. But this fallacious description confuses basic economic concepts, and is similar to a trick question often given to introductory economics students.
The argument being made is that falling prices lead consumers to delay purchase (as they await lower prices) which further lowers demand and leads to lower prices, etc., and therefore leads to a deflationary spiral. It is important to understand that this description contains elements of truth which make it sound credible, but it is important to separate truth from sophistry.
What Is True
First, what is true in this description. It is true that economists believe there are feedbacks in the macroeconomy. The idea, for example, is that if I decide to lower my spending, this will lower the income of retailers who might then themselves spend less, lowering others' incomes, etc. etc. It is important to recognize that though such feedbacks occur, they are generally thought to be finite (and small) in nature: each round of indirect effects are thought to be smaller than the previous. The total (indirect + direct) effect of some spending shock is generally thought to be not much larger than the initial shock: estimates of the spending "multiplier" (as it is called), which measures the ratio of the total effect to the initial shock, are on the order of 1.1.
Second, it is also true that the lower the rate of inflation, (or the higher the rate of deflation) the more spending rational consumers will delay until the future, all else the same. This relationship between consumer spending and inflation can be thought of as partly responsible for generating the so-called Phillip's Curve, which describes the relationship between output and inflation (again, all else the same).
A Trick Question from Introductory Economics
Evil economists (such as myself) often try to fool their introductory economics classes with a problem of the following type. "Suppose demand for good x falls because of some shock (such as lower income). This causes the price of good x to fall. But this fall in price in turn raises demand for the good, so the net effect of the shock is ambiguous." What's wrong with this reasoning?
The first two sentances are fine, but it is not true that the fall in price raises demand for the good. And why not? Isn't that how demand is supposed to work? Not quite -- the problem is one of definition. Demand is a relationship rather than a quantity: it describes the relationship between price and quantity that is demanded by consumers. So while it's true that quantity demanded is higher a lower price, it is not true that demand is lower. Graphically, it's the difference between a shift of the whole demand curve (which is a shift in demand) and a movement along the curve (changes in quantity demanded). In the trick question above, the income shock shifts the demand curve inward, lowering the quantity of good x consumed in the intersection with supply (i.e. in equilibrium); the price is also falls in this new equilibrium.
Back to Macro
In a similar way, the Phillip's curve represents a relationship between two macroeconomic variables: output and inflation. They are thought to be negatively related, in part because of the reason described above -- at lower levels of inflation, consumers optimally choose to spend less today. But analagous to the problem above, we don't expect a one-time shift in this relationship -- due to a shock to consumer confidence, for example -- to cause inflation levels to continue to fall and fall and fall. Instead, we expect a new stable relationship between inflation and output to emerge.
And although the norm in our economy has been one of steadily rising prices, i.e. inflation, there is no reason to expect this price-output relationship to suddenly become steeper if inflation gets so low it actually becomes negative. The problem in Japan and in the US during the Great Depression was not of a "deflationary spiral" but of falling aggregate demand that decreased both prices and output.
In other words, low inflation or even falling prices are not the source of the problem -- they are a mere symptom of overall economic weakness. And it is that on which Fed Policy should be focused.
Over 1/2 of US employment is in firms with at least 500 employees, and 2/3 is in firms with at least 100 employees. Is this what politicians are referring to when they refer to "small business" being the "engine of American employment?" Of course, some big businesses were once small businesses, but I have a hunch that most employment growth is also in big business; the big companies are the ones that stick around, while it's the little guys that have such a failure rate. And, in fact, US employment has only become more concentrated in large employers over the past decade.
So perhaps political rhetoric, and policy, should match with reality. Big business is where the jobs are.
See exciting commentary below.
So here are the numbers on oil reserves, as promised. I have grouped countries by their GDP/capita (income). Because the world income distribution is highly skewed, I have grouped countries in the following way: approximately top 10%, second 10%, third 10%; these are combined into a group called the "top third" -- which contains about 1/3 of the world's population. I also look at the second third and the third third.
Which countries are in these groups? The top (approximately) 10% of countries include the US, many countries and Europe, and also Kuwait. The second 10% contains most of OPEC, which is why oil reserves are so high for that group, but also countains other parts of Europe, Taiwan, and some of Latin America. The richest country in the third 10% is Poland, and the poorest is Paraguay. The Middle group is dominated by China, but also includes some sub-saharan African countries. At the bottom are India, Vietnam and other countries.
As you can see, countries with a lot of oil reserves tend to be richer. This is no big surprise, of course, except to strange economists with wacky theories! See my previous blog, but to recap: These wacky economists and their "I ate a brain tumor for breakfast" friends at the Boston Globe argue, I suppose, that the OPEC countries in the second 10% would be in the top 10% if they just didn't have the easy money from oil. Does anybody out there believe this?? I find it hard to believe. I suspect without the oil, the middle east might look a lot more like sub-saharan africa than America or Japan. Besides, if these economists are right, then the obvious policy implication for the middle east is that we should destroy all their oil wells, which would make everybody better off, right? Saddam's were doing the right thing by buring the oil wells! And the EVIL US tried to stop him.
Data Compiled from:
Oil Reserves: U.S. Geological Survey and Oil and Gas Journal estimates
Population Data: Census Bureau
Income Data: www.geographic.org
Also, thanks to my brother Caru Grasshopper (TM) for finding the oil reserves numbers.
A recent article in the Boston Globe argues that middle eastern countries have faired poorly because of the easy money they get from oil makes them complacent about development, and even cite famous economists who believe it. But it's not true.
It's hard to see, even on the face of it, why having no resources could be an advantage. Suppose you are a poor country with few resources. Much of your income will be spent on basic necessities, leaving little for investment in development, so you are likely to stay poor. With some exportable resource, you have export earnings with which to finance development. In fact this is the path that a great number of economies have taken and are taking: they start by selling raw goods or agricultural products, then use the export earnings to develop low-skill manufacturing and then move on to higher value added products and services. This process is much harder if you don't have a local income source for the early stages of development.
The evidence is also against it. For openers, the US is a major counterexample. There is much careful empirical work demonstrating that the USs vast natural resources were a huge benefit to its growth over the past two centuries. (In particular, the US has vast oil reserves, but has a variety of other resources.) Norway is another counterexample. The example of the development of Japan and Korea are sometimes held out as examples of how development occurs better without resources. In fact, these countries are the exception rather than the rule. In general, countries with greater oil reserves, or with greater amounts of other resources tend to be richer than other countries without them. In my next blog I will provide some basic statistics to support this.
I worry that frequent watching of the news coverage of the war in Iraq is poison for one's brain. Least insidiously, up-to-the-minute information is (understandably) often quite inaccurate; but as humans we tend not to be very effective at discounting information that comes from an incredible source. Once we've heard something, over time we tend to forget about the reliability of the source and just remember what we heard. (I believe that psychologists call this "source dissociation.") Thus, we may make false judgements based on innaccurate information if we watch too much "breaking" news.
More worrisome is I think that much of the information that does come out is derives directly or indirectly from the propoganda of interested parties. I suppose this is true of news reporting in general, but it all seems to take on a greater intensity during wartime. Imbedded reporters are limited in what they can say for serious security reasons, but agenda items such as maintaining morale, intimidating the enemy, etc. may affect what is being reported. Similar influences may affect the briefings of senior military or politicians on both sides. Even reporters not in the field may have some trouble maintaining objectivity in the face of a threat to American citizens.