Month: October 2006

Supply side Economics

Supply side economics revolves around the central concept that changes in economic growth can be brought about more rapidly by making changes in the ‘aggregate supply’ rather than changes in the ‘aggregate demand’.

Supply side economists prefer policies such as cuts in tax rate (Which increase the supply of workers and thereby increase employment, as a result increased incentive to work) to various other demand side policies such as changes caused about by monetary policies, such as an increase in the money supply or fiscal policies, such as a progressive tax.

Conservative economists are of the view that tax cuts need to be concomitant with cuts in government expenditure or purchases, so that the effect on the budget is neutral.

History of Supply-side Economics

Robert Mundell is the person who furnished the theoretical genius behind ‘supply-side economics.’ The ideas and premises of supply-side economics are described most lucidly in the writings of a political science and journalism graduate of UCLA, Jude Wanniski. Those writings, in turn, reveal that three individuals were primarily responsible for advancing the ideas of supply-side economics: Robert Mundell as the economic theoretician; Arthur Laffer as the pragmatic economist with a flair for public relations; and Jude Wanniski as the journalistic link between the two economists, the public, and the worlds of Wall Street finance and Washington politics. [Jett 2003]

America and Supply-side Economics

The US of A experimented with supply side policies in 1980. Ronald Reagan was the man behind it and his opponent, George H. W. Bush called it ‘Voodoo Economics’. Reagan cut the marginal tax rate on the highest income earners from 75% to 38%. His rhetoric was that if taxes were lowered, these rich would earn more and thus increase the gross taxes collected.

In a nutshell, here is Krugman’s account of the ascent and record of supply-side economics. Except for a few renegade professors like Arthur Laffer, supply-siders come from outside the economics profession. They come from journalism (Wall St. Journal columnists, Jude Wanniski, George Gilder), political staffs and think tanks. They convinced key Republicans that the cause for slowing U.S. economic growth was high taxation and excessive regulation. Supply-siders asserted big government was the problem. The cure required tax cuts, which would 1) bring back growth, 2) raise investment, and 3) enable deficit reduction. Disregarding sophisticated conservative economists like Martin Feldstein, politicians seized on the cruder, easy to peddle supply-side message that the economy would benefit from tax cuts – without concern for offsetting spending cuts.

The track record of early 1980’s tax changes can now be gauged from economic history regarding the three supposed benefits. Krugman presents and discusses the evidence summarized below.
1) The U.S. long-term rate of economic growth was not changed by supply-side tax cuts or by anything else since 1973. Productivity growth in the 80’s was 0.8% on an annual basis, compared to 2.8% in the prosperous period after World War II until 1973.
2) “By any measure, over any time period, investment fell” in the U.S. during the 1980’s, a result contrary to supply-side claims. As one example, net national savings was only 3.4% of GDP in the 1980’s, compared with 8% in the 1970’s.
3) In the absence of high economic growth or deep spending cuts, the deficit ballooned – to 4.9% of GDP in 1992 compared with 2.7% in 1981 when Ronald Reagan became President. The resulting debt will burden taxpayers for decades to come. [Neubauer 1996]

Conclusions

Pindyick and Rubinfeld say that some supply policies can shift actual output, but not all supply side policies can. Assistance of demand side policies is required.

If an economy is growing close to full employment level, i.e. with the presence of only natural unemployment(Frictional unemployment) then such ‘tax cuts’ will be beneficial. But, if such policies are implemented in developing countries, with the presence of large degrees of unemployment, all it will do is widen the inequalities of income between rich and poor.

Trade Cycles

Trade Cycle is defined as the existence of fluctuations in National Income over a variable time span. It was first observed by the English economist Sir William Petty.

On Keynesian Trade Cycles

The reason why Keynes referred to it as a ‘cycle’ is mainly due to the way in which Marginal Efficiency of Capital (MEC) fluctuates. [According to Keynes, MEC is equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price.] As investment increases, MEC decreases.

MEC, according to Keynes depends on
-Existing stock of Capital
-Current cost of production of Capital
-Currents expectation as in the future yield of Capital


‘

These Trade Cycles are characterised by ‘Booms’ (Peak) and ‘Crisis’ (Trough).
Crisis
The causes of ‘Crisis’ was
-A sudden collapse of MEC and not primarily a rise in rates of interest (roi)
A ‘Crisis’ is analogous to a slump in the share markets.

Boom
It is characterised by ‘optimistic expectations as to the future yield of capital goods sufficiently strong to offset their growing abundance and their rising costs of production and, probably, a rise in the rate of interest also.’

During the boom, ‘disillusion comes because doubts suddenly arise concerning the reliability of the prospective yield.’ And ‘once doubt begins it spreads rapidly.’ This eventually results in a crisis.

On Trade Cycle theories

It is a well observed economic phenomenon and the usual time span is of the order of 5 years. The Government tries to reduce the fluctuations of the trade cycles through various stabilization policies.

Some of the economists who are associated with Trade Cycles are Samuelson, Hicks, Goodwin, Phillips, Kalecki and Friedman.

In 2004, theSveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel was awarded to Finn E. Kydland and Edward C. Prescott “for their contributions to dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles”

References

1) The General Theory of Employment, Interest, and Money By J. M. Keynes
2) Dictionary of Economics, The Economist

The Demographic Dividend

India is growing with 7% GDP, Sensex crossing 10,000 and foreign reserves have crossed the $150 billion mark. Is this growth sustainable’ Yes it is, provided we reap the benefits of what is known as the ‘Demographic dividend’.

Simply stated, the demographic dividend occurs when a falling birth rate changes the age distribution, so that fewer investments are needed to meet the needs of the youngest age groups and resources are released for investment in economic development and family welfare. The falling birth rates reduce the ratio of the dependent population to the working population.

The demographic dividend, however, does not last forever. There is a limited window of opportunity. When the window of opportunity closes, those that do not take advantage of the demographic dividend will face renewed pressures in a position that is weaker than ever.

India’s current scene

India is and will remain for some time as one of the youngest countries in the world. A third of India’s population was below 15 years of age in 2000 and close to 20 per cent were young people in the 15-24 age groups. In 2020, the average Indian will be only 29 years old, compared with 37 in China and the US, 45 in West Europe and 48 in Japan.

But India’s developments in ‘human capital’ are exiguous. The poverty ratio for India is still somewhere around the 50% mark. Only 7% of the population is employed in the formal sector. Farmer suicides are being reported every now and then. The social infrastructure vis-‘-vis the physical infrastructure is disheartening.

The dividends

The generations of children born during periods of high fertility finally leave the dependent years and can become workers.

Working-age adults tend to earn more and can save more money than the very young.

And for given unemployment rates, the higher the ratio of those in the labour force to those outside it, the larger would be the surplus. If this larger surplus is mobilised for investment, growth would accelerate.

However, Fareed Zakaria in his book ‘The Future of Freedom’ depicts this bulge to be bad for the economy. He goes on to state that ‘A bulge of restless men in any country is bad news.’

Conclusion

To sum up, it is evident that India is entering the phase of demographic dividend. In order to realise maximum benefit from this population bulge, it is necessary that programmes aimed at improving health care facilities and education are undertaken. Moreover, farmer suicides are not decreasing; the debts are growing and burdening those employed in the informal sector generally and in agricultural activities particularly. Microfinance can help alleviate the farmers’ distress by granting loans without collaterals.

References

1) John Ross [2004]
1) C. P. Chandrasekhar and Jayati Ghosh [2006]

The Economics of Information-Part 2

On Information Economics

In ‘The Undercover Economist’, Tim Harford talks about information asymmetries in his third chapter titled ‘The inside story’.

He says that ‘Economists have known for a while that if one party to a deal has inside information and the other does not, then markets may not work as well as we would hope.’ He focuses his study mainly on the American health insurance. This is true for most other exchanges taking place in today’s markets. The stock market runs on ‘inside information’.

Harford goes on to say that ‘Sellers know whether the car they’re selling is a lemon or a peach. Buyers have to guess.’ Likewise, in other markets, sellers are advantaged with inside information.

‘The problems of imperfect information include adverse selection (lemons) and moral hazard.’ says the book. To make matters worse, the consumer finds it difficult to find out better alternatives.

He emphasises that Akerlof did not describe universal ignorance, but of a situation where one side knows more than the other.

Akerlof pointed to the prevalence and importance of similar information asymmetries, especially in developing economies. One of his illustrative examples of adverse selection is drawn from credit markets in India in the 1960s, where local lenders charged interest rates that were twice as high as the rates in large cities. However, a middleman who borrows money in town and then lends it in the countryside, but does not know the borrowers’ creditworthiness, risks attracting borrowers with poor repayment prospects, thereby becoming liable to heavy losses.

The producer (after being in the market for a sufficient while) knows how much the consumer is willing to pay for the product or service. But the consumer never knows the actual cost of production and nor does he know to what extent the producer is willing to lower the price. Thus, Consumer surplus is known by the producer, but the producer surplus is almost never known to the buyer. The consumer is extolled as the king of the market. Is the consumer really the king’