Economics in Minutes

by Niall Kishtainy

  Economic theory says that there are great gains to be had from trade. When two countries specialize in particular goods and engage in trade, both are better off. Protectionism is a policy under which countries close themselves off from international trade, often by putting tariffs (taxes) or quotas on foreign imports. Because these policies unravel the gains from trade, most economists argue that they are economically damaging. Often there are calls for protectionism during times of economic crisis: the hope is that growth and employment can be maintained by insulating the domestic economy from foreign competition. The problem is that trading partners may try similar policies themselves, sparking a trade war and eventually leading to lower trade and income in both countries, as happened during the Great Depression of the 1930s. Some economists argue that temporary, targeted protection can be useful to help countries develop ‘infant industries’ that need to be cushioned from foreign competition until they are efficient enough to compete internationally.

  Globalization and market integration

  Globalization can be a confusing, woolly term. From an economist’s point of view, it is about the integration of markets that were previously separated by geography. Globalization is enhanced when English potatoes and French potatoes compete for the same consumers in England and France, where before they were only bought and sold in their countries of origin. An indication of economic globalization, then, is the equalization of prices of goods in different places – potatoes in London and in Paris.

  Globalization occurs when transport costs become low enough to make it profitable to trade. The development of shipping and railways in the 19th century was a major spur. Governments can assist the process by cutting tariffs, or hinder it by raising them. Since the Second World War, globalization of markets for goods and services has proceeded apace. Financial globalization has also progressed. Labour migration is another, politically charged component of globalization.

  Trade and geography

  Economists have recently started to think of industrial specialization and patterns of international trade as arising more or less by accident. The classical theory of trade says that one country becomes the leading exporter of cloth because it is abundant in sheep, another of wine because it has the right weather. In fact, a lot of trade goes on between industrialized economies with essentially similar natural resources and populations.

  However, an industry like steel production is much more efficient at a large scale, because of the big investments in plant and machinery that initially have to be made. So once one country starts producing steel it builds up a cost advantage. This makes it hard for other countries to catch up, so the country comes to dominate steel exports. Some other country might just as well have been the first to set up a steel plant, in which case it would have become the leading producer.

  Fair trade

  The aim of fair trade organizations is to funnel more of the gains from international trade to producers in developing countries. Consider a jar of coffee in the supermarket: fair trade advocates point out that the revenues of the Ethiopian coffee farmer from the sale of the beans that went into the jar form only a fraction of the supermarket price – the rest consists of the costs and profit margins of intermediaries.

  When the farmer joins a fair trade scheme, he is guaranteed a minimum price, in return for which he has to adhere to labour and environmental standards. His coffee is sold under a fair trade certification. Western consumers who value fair trade aims are willing to pay a bit more for the coffee. The hope is that such measures smooth the fluctuations in income faced by small farmers in poor countries as the market prices of crops move up and down. However, the fair trade movement can be criticized: some argue that it does not help the poorest, who are predominantly casual labourers rather than farmers.

  The Bretton Woods system

  During the Great Depression of the 1930s, many countries shut out foreign imports to protect domestic markets, leading to a disintegration of the international economy. A 1944 conference at Bretton Woods, New Hampshire, laid the foundations for rebuilding global cooperation. Countries’ exchange rates were tied to the US dollar. The International Monetary Fund and World Bank were set up to help governments with financing and economic development. Another aim was to reverse protectionism. The General Agreement on Tariffs and Trade (GATT), later to become the World Trade Organization, oversaw rounds of international trade negotiations that continue to the present.

  The system presided over several decades of stable growth, but ended in the early 1970s, after which the world saw increased economic instability. In the wake of the recent financial crisis, some commentators, evoking Bretton Woods, have argued for a another remodelling of the international finanscial system.

  The US trade deficit and global imbalances

  As the largest economy in the world, the United States has run a ‘trade deficit’ for many years, importing more than it exports. Such deficits have to be funded by capital flows from abroad. The large US deficit, and corresponding inflow of foreign money, are global imbalances in the international trading system. Such imbalances are a fact of economic life and don’t necessarily pose problems, but the size and persistence of today’s imbalances worry commentators, some of whom argue that they fed into the recent financial crisis. The US trade deficit has been mirrored by Chinese surpluses that generated a flow of capital to the rest of the world and contributed to a global ‘savings glut’. These savings flooded Western financial markets, leading to a boom in lending, some of which went into the overly liberal mortgage lending (see Financial crises) that went on to undermine financial markets. The size of the US trade deficit remains controversial – some are concerned that if capital flows decline, it will become unsustainable and the economy will suffer a major shock.

  International capital flows

  Gross international capital flows, 1980–2005

  In the last few decades, the flow of capital between countries has grown much faster than world economic output. Capital moves to a country when someone buys its shares or bonds or makes direct investments in its firms. Most capital moves between advanced industrial nations, but a few developing nations attract some of it. Without foreign capital, a country can only invest the money that its citizens save: capital inflows relieve this constraint, enhancing growth potential.

  Measures by a country to open its economy to foreign investment are known as capital liberalization. For developing nations especially, the benefits of such policies have been patchier than economic models might suggest, and some even blame it for the increased prevalence of financial crises in the developing world. It could be that different kinds of capital flows have different impacts: for example, some studies suggest that direct investment in a country’s businesses has more of an effect on growth than loans.

  Multinational firms

  Multinational firms are those which operate factories and offices in different countries. Their rise has been an important part of the globalization of markets (see Globalization and market integration). Why do firms need to run their own operations in countries where they wish to sell? Suppose that British Pills Incorporated wants to launch a new drug in India: it could simply produce the drug in the UK and export it. There might, however, be advantages to producing in India, such as the availability of cheaper raw materials and labour. Even so, why not license an Indian firm to produce the drug? One reason is that British Pills might have a ‘firm specific asset’, perhaps a special production method or drug formula. The asset’s value would decline if it gave access to another firm – it might soon be used to make a competing product. A better option would be for British Pills to set up its own operations in India. Multinationals’ decisions about where to locate overseas facilities are influenced by factors including market size, local production costs, tax levels and the legal environment.

  Labour migration

  Labour migration is an important facet of the development of markets. When countries industrialize, worke
rs move from rural to urban areas, attracted by the higher wages offered by industrial enterprises. A similar phenomenon happens internationally: huge numbers of migrants flowed to the New World during the 19th century and international migration has remained important ever since. As with internal migration, economists stress the role of wage gaps between different countries in generating international migration: migrants flow from low-wage to high-wage countries. Eventually one might see a levelling off, if wages begin to equalize across countries. In practice, migration is a far more complex phenomenon than simple economic models suggest. All sorts of cultural and social factors are involved, and the issue has become highly politicized. Nevertheless, even basic economics can be useful here, if only to remind us that labour migration is as much a part of the logic of globalization as the expansion of international markets for goods and finance.

  Real and nominal exchange rates

  Exchange rates – the cost of converting pounds into US dollars, for example – are determined by the demand and supply of different currencies. They mediate any interaction between buyers and sellers of goods and services in different countries. The nominal exchange rate is that displayed on a bank’s list of rates – US$1 equaling UK£0.65, for example.

  However, this nominal exchange rate doesn’t tell you what you could actually buy in a foreign country with your own money. By taking account of countries’ price levels, the real exchange rate measures this. It might tell you how much British apples cost in terms of American apples. Britain’s real exchange rate goes up when its nominal rate rises, but also if its goods get more expensive, or American goods get cheaper. A fall in Britain’s real exchange rate means that its goods have become cheaper compared to other countries. This encourages consumers at home and abroad to buy more British goods.

  Fixed and floating exchange rate systems

  Systems of exchange rates lie on a spectrum between fixed and floating. In a pure floating exchange rate system, the price of one currency in terms of another arises out of market supply and demand for the currency – the price of the currency tends to rise when demand for it goes up or supply falls.

  In contrast, an exchange rate is fixed when a set rate is maintained: for example, the Argentinian government might fix its exchange rate at two pesos to the US dollar. There are also intermediate arrangements, such as the establishment of exchange-rate bands within which a currency is allowed to fluctuate. A fixed exchange rate binds a country’s monetary policy – its control over money supply and interest rates – because this has to be consistent with the specified rate. Compared to a floating exchange rate, there is less freedom to alter monetary policy in response to domestic economic conditions. Some, however, argue that fixed exchange rates can enhance economic stability.

  The gold standard

  Under the gold standard, gold is used as currency – or more commonly, paper currency can be converted into gold. The gold standard was in use in the early part of the 20th century and some look back on it with nostalgia, believing it to have enhanced the stability of the international monetary system. Under the gold standard, currencies are given a set value in terms of gold. This means that their values in terms of other currencies – their exchange rates – are also fixed. When this works well, it can reduce trading uncertainties. It can also hold governments to the maintenance of price stability because the authorities cannot easily expand a money supply that has to be backed by the gold to honour it. However, at other times this can act as a straitjacket on economies: during the Great Depression it limited the ability of governments to stimulate their economies through expansion of the money supply, prolonging the downturn. While many economists value price discipline and stable currencies, few would now advocate a return to a traditional gold standard.

  Currency crises

  Since the 1970s, currency crises have become increasingly common. Crises occur when a currency starts to get sold in large amounts, depressing its value. If the currency is ‘fixed’ (maintained at a particular rate), then that rate has to be abandoned in what is known as a devaluation. One type of crisis happens when there is a conflict between the exchange rate and other areas of economic policy. Suppose a government is spending more than it collects in taxes: if it finances the difference by increasing the money supply, this lowers the value of its currency. To maintain the exchange rate, the government must then use foreign exchange reserves to buy its own currency. Eventually, though, the government runs out of reserves and the currency has to be devalued. Other theories of currency crisis suggest that they may be self-fulfilling: many people worrying about the strength of the currency can be enough to trigger sell-offs and a crisis. Currency crises in developing countries over recent decades, meanwhile, were precipitated by a sudden drying-up of foreign capital inflows.

  Single currencies

  A single world currency would surely be too tight a constraint on so many diverse economies, while separate currencies for every town would hopelessly complicate economic life. For historical reasons, most currencies have evolved within borders, but many European countries have recently opted for a single, shared currency – the euro. If currencies don’t have to coincide with national borders, then what is the optimal coverage of a currency? When trading partners share a single currency, they reduce currency conversion costs and boost trade. However, a country with its own currency sets its own monetary policy (the level of money supply and interest rates) – power that it gives up under a single currency. In the case of the euro, monetary policy is decided by the European Central Bank. This works well when the economic cycles of member states are synchronized, but problems arise if countries need different monetary policies, as happened in the wake of the economic crisis that began in 2008. Questions are now being asked about whether Europe really is an optimal currency area.

  Exchange rate depreciation

  If the pound was worth $2.50 last week, but $2.30 today, its value has fallen: the pound has depreciated, the dollar appreciated. When the exchange rate can move freely, what determines its level? In simple terms, the price of a currency is like that for pens: it is determined by supply and demand. A country with high inflation will tend to see a depreciating exchange rate, because the currency’s purchasing power falls. Higher interest rates will tend to draw in foreign capital and cause the exchange rate to rise. The exchange rate is also influenced by the level of imports and exports: the trade deficit that occurs when a country’s imports exceed exports causes depreciation of its currency. This can be helpful, however, because it makes domestic goods more internationally competitive and helps to boost exports. In modern globalized capital markets, investors’ perceptions about the riskiness of putting money into countries have their own impacts on the exchange rate: political instability can deter investors and lead to declines in currencies’ values.

  For a given level of demand, an increase in the supply of currency will lead to a depreciation in the market value.

  Economics and ethics

  The founders of economics – figures such as Adam Smith and John Stuart Mill (opposite) – were philosophers: their work fused ethical enquiry with economic analysis. Since their time, however, economics and moral philosophy have become much less connected. Modern economics, with its mathematical models and sophisticated statistics, is often viewed as an objective, scientific discipline dealing with hard-nosed realities. In contrast, ethics is seen as subjective, not amenable to scientific analysis and existing in a wholly separate realm. Perhaps the central question of economics, however, is how to allocate scarce resources among individuals with conflicting desires. The question of whether to build more hospitals, universities or shopping centres has a strong ethical dimension, and many thinkers have continued to be interested in the interaction between economics and ethics. Recent studies of individual economic behaviour have found that it is driven as much by moral beliefs such as principles of fairness as it is by economic calculation.

  Religion and the economy

>   Economists have become increasingly interested in the way that social norms and beliefs – including religion – influence countries’ economic fortunes. Religious organizations can be viewed as a kind of ‘social capital’ (see Social capital) – networks and relationships between individuals that may be economically beneficial. On the other hand, religious restrictions, such as those on the participation of women in the labour market, can hinder market expansion. German sociologist and economist Max Weber was one of the first to look at the implications of religious belief for economic performance. He famously argued that Protestantism propelled economic development in Europe by making hard work virtuous. Thrift and profit-making became an article of faith, so Weber argued, and encouraged the rise of capitalism. More recently, economists have tried to explain the rise of certain Asian countries through ‘Asian-values’ or Confucianism. At a theoretical level, many of these ideas remain speculative, and empirically disentangling the impacts of religion in different societies is fraught with difficulty.

  Economics and culture

  If people are economically rational, why do they give presents?