Comparative Political Economy

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Comparative Political Economy

• Western Industrialized Democracies

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I. The Classical View of Macroeconomics

• Long-run growth determined by population (labor
  supply), technology, and wealth (supply of
  capital)
• Market self-corrects for deviations from long-run
  growth rate (no politics, hence no political
  economy)
• Key Assumptions Flexible Wages, Flexible Prices
• Implications
• No one loses a job when demand is low (wages
  fall, or they get another job with lower wages)
• No unsold inventories (suppliers simply lower
  prices as needed)

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E. Problem Ever-larger economic shocks
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II. Keynesian Macroeconomics A Simplified
Explanation

• Keynes In the long run we are all dead. ?
  Focus on managing short-run fluctuations
• Key Variables
• Dependent variables
• Output Real Gross Domestic Product (GDP)
• Inflation Rate of increase in prices
• Unemployment People looking for work but unable
  to find it

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2. Independent Variables

• Consumption Function (70 of US GDP)
• Primarily determined by disposable income Income
  Net Taxes
• Net Taxes Taxes - Transfers

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Consumption and Disposable Income
Consumption function C c0 C1YD
Consumption, c
Slope c1
Disposable Income,YD
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b. Investment (10 of US GDP)
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c. Government spending (20 of US GDP after
transfers)
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B. Economic growth in the short run Supply and
Demand

• Aggregate Demand
• Definition How much stuff everyone in society
  buys at a given price level
• Demand Consumption Investment Government
  Spending Exports Imports

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Aggregate demand curve
Higher prices
Lower prices
Aggregate demand
Less output demanded
More output demanded
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2. Aggregate Supply

• Definition How much stuff firms choose to
  produce and sell at each price level
• Supply curve determined by income (ability to
  produce at a given price level)

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Aggregate Supply Curve
Higher prices
Aggregate supply
More output supplied
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3. Equilibrium Where supply meets demand

• Best single predictor of economic output.

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b. Equilibrium effects of increases in aggregate
demand on output
Price level
AD1
O
Y2
Y1
Y3
Y4
YP
National output
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c. What shifts aggregate demand?

• Remember the equation Demand Consumption
  Investment Government Spending Exports
  Imports
• So changes in any one of these independent
  variables can shift aggregate demand at a given
  price level (policy levers ? political economy)

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4. Disequilibrium

• Definition Actual price level is higher or lower
  than equilibrium point
• Equilibrium may be unstable Example of Great
  Depression

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Macro Disequilibrium Oversupply and Low Demand
Aggregate supply
P1
PE
Aggregate demand
QE
S1
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c. Equilibrium may be Undesired Excessive
Unemployment
Aggregate demand
Aggregate supply
E
PE
F
P
Equilibrium output
Full employment
QE
QF
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C. Keynesian Policy Recommendations

• Focus on demand side by manipulating
  independent variables such as government spending
  and taxes
• If people demand a product, producers will supply
  it ? get money into peoples hands and production
  will rise
• Spending increases more effective than tax cuts
  All of spending is consumption but some of tax
  cuts will be saved by taxpayers instead of being
  used for consumption

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D. The Success of Keynesian Policies
Countercyclical Management
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III. Alternatives to Keynesian Macroeconomics

• Problem Emergence of stagflation in 1970s
• Cause External force shifted supply curve (firms
  less willing to supply at a given price)
• Leading suspect Oil price shocks increased costs
  of production so much that even large increases
  in price didnt stimulate more production
  (simultaneous inflation and unemployment ?
  recession)
• Effect Negated the Philips Curve

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Unemployment and inflation The Philips Curve
(US, 1960s)
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BUT High inflation can create expectations of
future inflation
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3. Why not increase government spending?

• Increased spending increased inflation even
  further (usually not a problem, since inflation
  is low during recessions)
• Very large deficits limited governments ability
  to spend (in US Vietnam expenses and increased
  social spending)

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B. Demand-side alternative Monetarism

• Interest rates and money supply affect peoples
  willingness to buy at a given price
• Shift demand curve by manipulating interest rates
  or money supply (Interest rates actually easier
  to manipulate! We dont know what money is
  anymore.)
• Increase interest rates (reduce money supply) to
  cut inflation at expense of increasing
  unemployment (induce a recession to prevent
  stagflation). Key is to alter expectations of
  future inflation.
• Cut interest rates to lower unemployment at
  expense of increasing inflation (economic
  stimulus)

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5. Example The US Monetary System

• The Federal Reserve Board Created in 1913 to act
  as a central bank (mixes public appointees with
  private banks)

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b. Functions of the Federal Reserve

• Conduct Monetary Policy
• Formal mandate Low inflation and Low
  Unemployment
• Actual policy emphasizes low inflation over full
  employment or economic growth
• Serve as a lender of last resort to commercial
  banks within the District
• Issue Currency In God we Trust
• Provide Banking Services to the U.S. Government
• Supervise and regulate financial institutions

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c. The FRB Toolkit

• Buying/selling government securities
• Stimulation Fed purchases U.S. Government
  Securities in the bond market (U.S. Treasury
  Notes) Raises bond prices reduces interest
  rates
• Cash flows from the Fed to sellers of bonds
  sellers deposit cash in their banks, thereby
  increasing the nations deposits and the excess
  reserves of the banking industry
• Restraint Fed sells U.S. Government Securities
  in the bond market (U.S. Treasury Notes) Lowers
  bond prices increases interest rates
• Cash flows from the banks to buyers of bonds and
  ultimately to the Fed, thereby reducing the
  deposit accounts and restricting the ability of
  commercial banks to loan money

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ii. Alter the Fed Funds or Discount Rates

• Fed Funds Rate the interest rate commercial
  banks must charge one another to lend or borrow
  on an overnight basis for reserve management
  purposes
• Discount Rate the interest rate commercial banks
  must pay the Fed to borrow directly from the Fed
  for reserve management purposes

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iii. The reserve rate The Feds ultimate weapon

• Amount of cash banks have to keep on hand to
  cover withdrawals
• Use of this tool would be perceived as a reaction
  to extraordinary events
• Fed will be very cautious and publicize its
  intentions well in advance
• Last time required reserves changed 1980
  resulted in a credit crunch that plunged the
  economy into the worst recession since the Great
  Depression

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6. The role of Banks in Monetary Policy

• a. Banks Create Money Banks can be viewed as
  counterfeit operations authorized by the
  government, and are an essential tool in
  affecting monetary policy
• Banks lend money that they dont have -- so they
  are essentially minting their own currency!
• Reserve requirements set by the government
  determine the extent to which banks can
  counterfeit

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b. Banks depend on confidence

• Customers could bankrupt a bank simply by asking
  for all of their reserves back, which they can do
  at any time.
• Customers dont ask for their money back when
  counterfeiting is profitable and they earn a
  part of the returns (interest)
• Customers will tolerate the behavior only as long
  as they believe that the bank is reputable in
  this activity

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c. Money creation through fractional reserves
The money creation process Making one loan
creates the opportunity to make another loan, a
process which continues in perpetuity. Step 1
Bank issues a promissory note for which there is
no direct reserve. (ie. the bank makes a loan
and gives the borrower a receipt against that
banks reserves) Step 2 This receipt (loan) is
traded for a good or service (promissory note is
passed on to a new holder) Step 3 The
promissory note is deposited back into a bank by
the new holder, creating a new deposit (bank
liability). Step 4 The promissory note is
available once again to be loaned.
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Money Creation Example

• A bank receives 100 Million in deposits, keeps
  20 million in reserve.
• But the 80M in loans returns to the banking
  system somewhere else -- the second generation
  bank

The third generation bank receives 64 million of
new loan deposits, allowing another 51.2 million
in loans
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7. Is Monetary Policy Effective?

• Easy to curb inflation (excess money) -- at cost
  of lower growth / recession and increased
  unemployment
• Harder to stimulate growth
• Example Fed can lower interest rates, increase
  the banks deposits BUT
• It cannot force a broke person (business) to
  borrow
• Good risks in prosperous times become poor risks
  in recessionary times
• Central banks ability to stimulate often
  compared to problem of trying to push a string
  no matter how much effort you give it, it just
  doesnt move much

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C. Supply-side economics

• Adverse shift in supply curve means BOTH higher
  prices (inflation) AND lower output (recession
  and unemployment)
• Demand-side shifts cannot simultaneously boost
  production and lower inflation
• Solution Shift supply curve by altering ability
  and willingness of firms to produce at a given
  price point
• Policy levers Corporate tax cuts, deregulation,
  increased labor supply (immigration), lower
  tariffs on raw materials, education and training
  (increases in per-worker productivity) etc.

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D. Comparison Keynes, Monetarists, and
Supply-Siders
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1. Responding to Recession
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2. Responding to Inflation
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E. Conclusions

• Economics has become political Few classical
  economists around anymore, and they dont get to
  stay in office!
• Political choices (fiscal policy, monetary
  policy, trade policy, immigration policy, etc)
  affect economic outcomes
• Political Business Cycle Desire to stimulate
  economy before election at expense of
  slowdown/recession after election

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4. Summary The Macro Political Economy
DETERMINANTS
OUTCOMES
MACRO ECONOMY
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V. Characteristics of Monetary Policy

• The Choices
• Central Bank dependence vs independence

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The Time Inconsistency Problem

• Policymakers have incentives to promise low
  inflation (economic stability, prevent more
  inflation)
• Policymakers have incentives to renege on
  promises of low inflation to increase
  growth/employment (political business cycle)
• Problem Private actors know these incentives and
  therefore anticipate high inflation by raising
  wages and prices, so short-term stimulus fails to
  do anything except further increase inflation
• Solution Central bank independence makes
  low-inflation promises credible, prevents
  political manipulation

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I. Characteristics of Monetary Policy

• The Choices
• Central Bank dependence vs independence
• Exchange rate regimes fixed vs. floating

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Exchange Rates Fixed vs. Floating

• Floating Government has more autonomy because
  has no duty to pay specific amount for own
  currency (not backed with gold or other reserves)
• Fixed Government promises to exchange specific
  amount of gold/reserves for currency. Government
  cannot release too much money or speculators may
  try to cash in and break the bank

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I. Characteristics of Monetary Policy

• The Choices
• Central Bank dependence vs independence
• Exchange rate regimes fixed vs. floating
• Wage-setting institutions centralized vs
  decentralized

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Wage Coordination Problem

• Even where workers wish to avoid wage-price
  spiral, incentives to free-ride on other workers
  restraint
• So each union assumes that other settlements will
  be inflationary and compensates by raising its
  own demands
• Coordinated bargaining reduces ability to
  free-ride by imposing same agreement on all
  workers allows incomes policy

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4. Comparison Economic Institutions in Five
Industrialized Democracies
Increased from Low in last 20 years
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IV. Economic Learning by Leaders, 1973-2000

• Cross-national differences are not static
  Countries seem to learn and change in response
  to crises
• Three types of change
• Alter the usual variables (incrementalism)
• Try a different variable (innovation)
• Rethink how all settings work together and alter
  many at once (paradigm shift)

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A. Japan

• Initial system Large, interlocking alliances
  with government sponsorship (keiretsu)
• Dangers of inflation High growth rates combined
  with fear of social instability from unemployment
• National labor talks produce 30 wage increases
• 1973 Oil Shock Policy inconsistency
• Japan received 82 of oil from Middle East
• Initial price shock causes inflation fears
• Workers demand raises to compensate
• Increased wages lower profits ? lower investment
  and recession (worst one in any industrialized
  nation in terms)
• Attempts to tighten money to fight inflation
  deepen recession
• Crisis ends when price shock stabilizes, prices
  allowed to rise, full employment resumes

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3. 1979 Oil Shock Consistency

• Response Immediate tightening of money supply ?
  only mild reduction in profits/investment
• Fine-tuning prevented wage-price spiral

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4. The 1980s Export-led growth

• Huge trade surplus bolsters demand throughout
  1980s
• However, non-export sectors begin to encounter
  problems (low productivity increases, unable to
  lay off workers)
• Banks tied to failing enterprises prop them up
  with profits from successful ones (no problem as
  long as exports continue to surge)
• Profits from exports lead to easy money for
  banks ? speculation in stocks and real estate
• 1986-1990 The Bubble Stocks and real estate bid
  up by bankers and investors ? choicest parcels
  bid up to 93,000 per square foot

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5. Early 1990s The Bubble Bursts
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5. Early 1990s The Bubble Bursts

• Late 1989 Central Bank raises interest rates in
  effort to deflate bubble --gt reduces investment
  in stock market, popping a bubble in stocks ?
  Crash

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The Stock Market Crashes
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5. Early 1990s The Bubble Bursts

• Late 1989 Central Bank raises interest rates in
  effort to deflate bubble --gt reduces investment
  in stock market, popping a bubble in stocks ?
  Crash
• Failing domestic enterprises lead banks to slow
  investment, call in some loans ? discover many
  loans are unrepayable
• Result is credit crunch as businesses and banks
  (tied together) try to reduce own debt load
  instead of expanding production

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A Credit Crunch Emerges
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6. The Lost Decade A Failure of Governance?

• 1988 law reduces workweek from 44 to 40 hours by
  1992 (? lower per-worker productivity)
• Government maintains tight money supply, leading
  to deflation (money sucked out of economy leads
  to expectations of lower prices, leading to
  saving instead of consumption, leading to price
  cuts, etc)
• Government tries to loosen money supply by
  cutting interest rates, but even ZERO interest
  fails to spark investment (business cartels are
  trying to reduce debt load and banks are skittish
  about lending)
• By 2004, prime "A" property in Tokyo's financial
  districts had slumped to less than 1 percent of
  its peak

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GDP Growth Rates (Compare to US 2.5 for 1990s)
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B. United Kingdom

• Initial system Internal and external goals
• Internal Commitment to full employment, to be
  achieved by wage restraint (politically unstable
  combination) ? general tool of incomes policy.
  Inflation fought by measures to increase
  production ( lower unit prices, in theory, but
  failed).
• External Maintain value of the pound to sustain
  Commonwealth stability/trade (removed certain
  monetary options like devaluing currency or
  inflation)

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2. The 1973 Crisis Political Instability and
Paradigm Shift

• Conservatives lose power
• The Social Contract Informal agreement between
  Labour and labor
• Labour converts to monetarism! Exchanges promise
  of no price rises for voluntary wage restraint.
  Allows pound to fall.
• Bargain fails subsidies and sales tax cuts to
  hold down prices lead to huge deficits ?
  inflation through government spending monetary
  instruments fail to control money supply until
  mid-1980s government consistently overestimates
  future productivity growth
• Wage-price spiral follows, along with recession

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3. The 1979 Crisis Thatcherism

• Winter of Discontent Labor turns on Labour
• 1979 Thatcher elected on promises to cut
  spending, cut taxes, curb inflation, deregulate
  (supply-side stimulation and monetarist
  deflation). Unable to effectively control money
  supply (lack of adequate measures remember the
  Feds solution)
• Government soon abandons attempts to cut
  spending/taxes ? both rise
• 1980 North Sea oil begins to increase revenues
  BUT leads to overpricing of British goods (Dutch
  disease exchange rate distortions) and decline
  in domestic manufacturing

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4. The 1980s Monetarism abandoned

• Problem Monetary control without proper exchange
  rate controls killed inflation but also much of
  the UK manufacturing base
• Government gradually seeks integration with
  European monetary policy to control both
  inflation and exchange rates
• Integration fails Europe unable to stabilize
  pound (well see why when we get to Germany)

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5. The 1990s Return to stability

• Anti-inflation policies finally pay off
  Government began targeting real interest rates
  instead of nominal rates or money supply
• Pound allowed to sink
• 1997 Central bank independence increased

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C. France

• Before the crises Dirigisme
• Government owns energy, infrastructure, defense,
  communications industries
• Unions are weak (no exclusivity or closed shops),
  so workers look to government to set wages and
  working conditions

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2. 1973 Government tries to cushion shock

• Efforts to increase social spending and stimulate
  economy lead to high rates of inflation
• 1976 New P-M focuses on deflation. Allows
  unemployment to rise in order to hold down
  inflation. Balanced budgets become norm.
• No effort to deal with unions by Conservative
  governments

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3. 1979 Socialism Fails

• Voters elect Socialists
• Socialists nationalize more industries to prevent
  them from failing and achieve strategic control
  of economic development
• Socialists raise wages (also increase benefits,
  lower hours per week) and make it harder to fire
  union leaders and other workers (thus increasing
  unemployment), also stimulate economy through
  spending, hoping to increase productivity enough
  to offset inflation (complete failure)

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Unemployment in France
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4. The 1980s Malaise

• Recession avoided in France BUT cost was
  continued high unemployment and inflation
• Socialists retreat from economic stimulus,
  lowering inflation and tying the Franc to the DM
  -- BUT are blamed for previous failures and lose
  power in 1986

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5. The 1990s Still More Malaise

• The plan Competitive disinflation argued that
  keeping inflation lower than neighbors (UK and
  Germany) would make France more competitive and
  increase unemployment
• Central Bank independence dramatically increased
  to fight inflation
• Problem Huge gains in competitiveness
  unacceptable to French trading partners

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D. (West) Germany

• Prior to crisis Strong, independent central bank
  (with price stabilization mandate) combined with
  national-level labor-industry wage bargaining.
  High job security, with government tasked with
  full employment and unions free to pursue max
  of economy as wages.
• The 1973 Shock Government implements
  counter-cyclical Keynesian policies, but has
  little effect on unemployment (manages to
  increase deficit/debt, however). Hiring freeze
  on foreign workers has some effect, causing some
  migration.

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3. The 1979 Shock

• Shock is widely perceived as loss of
  competitiveness (real effect was largely on
  exchange rates)
• Business anticipates downturn and cuts
  investment, people then follow by cutting
  consumption
• Policy recommendations from Council of Economic
  Experts Dont stimulate demand-side at all,
  since this would cause inflation. Instead reduce
  regulations on investment. (Shared by Bundesbank
  and FRG)
• Policy recommendations from Trade Unions
  Stimulate demand to provide full employment
  (shared by SPD)
• Government coalition (SPD plus FDP) is divided
  FDP joins CDU to form conservative government in
  1982

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4. The 1980s A Conservative Approach?

• Little deregulation subsidies not cut mild
  reductions in spending growth and taxes
• Firms do invest more but they invest in
  labor-substitution instead of new jobs!
• Inflation controlled by Bundesbank, unemployment
  continues through most of decade

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5. The 1990s Reunification

• Immediate problem East German industry cannot
  compete ? high unemployment
• West Germany promises to exchange DM for Ostmarks
  11 (essentially means printing lots of money)
• Massive wage increases for East German workers
  (benefit of West German labor contracts)
• Bundesbank restricts money supply to prevent
  massive inflation (? recession in 1993 and
  unemployment throughout decade)

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E. Conclusions National Political Differences
Drive Economic Differences

• Democratic leaders learn When economic programs
  fail, leaders try new ideas ? policy
  inconsistency
• Greater crises greater changes in economic
  management

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The Economic Crisis, 1972-1983
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E. Conclusions National Political Differences
Drive Economic Differences

• Democratic leaders learn When economic programs
  fail, leaders try new ideas ? policy
  inconsistency
• Greater crises greater changes in economic
  management
• Economic voting can be sophisticated French
  Socialists dont get credit for tight money and
  German Conservatives arent blamed for high
  unemployment

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E. Conclusions National Political Differences
Drive Economic Differences

• Democratic leaders learn When economic programs
  fail, leaders try new ideas ? policy
  inconsistency
• Greater crises greater changes in economic
  management
• Economic voting can be sophisticated French
  Socialists dont get credit for tight money and
  German Conservatives arent blamed for high
  unemployment
• Path dependence Previous choices can constrain
  current policy options
• Critical variables include central bank
  independence, exchange rates, wage-setting
  institutions, and job protection
• International trade critical to most non-US
  economies