Thursday, December 18, 2008

Income Inequality, Part II.

Luckily for you (sarcasm), I engrossed myself in income inequality literature and blogs over the past couple of days and I excitedly found very good information! I really wanted to conduct my own regression having the Gini Coefficient as an independent variable, and dependent variables for measuring how quickly a country exports more technologically advanced goods, educational differences and control for primary commodity export dependence, inflation, etc.

But alas, until I get $500 for SAS or eViews, I am stuck hypothesizing. Here is my guess: that income inequality has risen where countries have adopted technologically advanced products-- and that although manufacturing has been shown to raise a country's overall GDP, the spread of wealth might be quite large. Consider Nazi Germany-- a cliched example, I admit, but in this case it might work. Mandatory wage-holding down policies created a decline in the share of wages to national income. Though total GDP increased, the quality of life deteriorated. This must have meant that income inequality rose-- and indeed, according to Tyler Cowen (the Marginal Revolution blog), the income share of the bottom half of the income distribution fell from 25 to 18% from 1928-1936, while the increases in profits were incredible.

There might be something to the Kuznet's inverse-U hypothesis (1955): that is, that income inequality will raise during an era of heavy industrialization as the skilled workforce becomes more valuable and more heavily demanded. After time, according to Kuznets, people will re-train themselves and their offspring to move in this new direction, returning to normal levels of inequality.

I do not think this is the whole story. In fact, it does not do much to explain why there has been a U-shaped (versus Kuznet's inverse U-shaped) income inequality curve over the last century in America. Douglas Massey, an economics sociologist from Princeton, suggests that there has been an increasing trend to model markets after the natural world- something I mentioned previously. In fact, markets are not states of nature, and do not react like living beings. They "respond" based on human interaction and human desire. Markets are created by governments. And because markets are not natural, the government's inclinations are particularly important in determining their structure. After the 1970s, income inequality took a sharp turn upward, and Massey suggests (as I mostly agree) that it was due to a change in the political atmosphere. Some well-known causes for income inequality include educational differences, immigration (with a minimal effect), a shift in skilled labor demand with technological progress, unionization, globalisation and a decline in the real value of the minimum wage.

I will begin with unionization. In 1947, the Taft-Hartley Act was passed and restricted the power of labor unions. Specifically, it allowed states to dictate their own labor standards. The southern states eagerly amended their union laws in order to further exclude blacks from being able to organize. They did so by outlawing "closed shop", punishing actions against companies, a mandatory "cooling-off" period in which workers were not allowed to strike, investigation and possible suing of unions if they are found to be destructive to businesses, etc. There was a temporary stabilization in unionization, but minority workers began to organize themselves again, which lead to another anti-union legislative move in 1959, decertifying certain unions. Finally, Johnson's Great Society programs began to deracialize the heavily racialized New Deal programs that Roosevent initiated, of which radically excluded blacks from receiving public assistance or participating in the workforce programs. The Civil Rights Act in the 1960s helped to allow minorities to unionize with greater ease and less barriers, leading to a lower inequality level. Unions have lost their power recently, and only a small percentage of private companies are unionized in America, at much lower levels than other industrialized nations. There is a clear trend between the ability to unionize and an income gap.

The 1920s was a period of low taxation and heavy income inequality. World War II took icnome away from businesses, which decreased the earnings of business owners, creating a more equal post-tax society. President Johnson moved to an extremely progressive tax system, which made the after-tax income gap much narrower. What followed this relative equality in incomes was a period of radical fiscally conservative ideology, beginning with President Nixon and continuing almost steadily (excluding a minor dip during the Clinton era) until the present-day Bush administration. President Reagan's notion of the "welfare queen" began a pattern of legislation to cut welfare eligibility and lower taxes for the wealthiest Americans.

A lot of the analysis of income inequality requires you to think of the whole as the a set of a few individuals. So think of the society as a small group of people. One person in the group has hit the proverbial jackpot. He has made an enormous amount of money doing a particular job. The only thing is, only he can do this job, because he has the skills to do so, and he excludes other people from this job. Let's say he's a hedge fund manager. Nobody else in the group knows how to get where he is at the time, so they do what they can and try to live like he does. Meanwhile, the wealth that he has accumulated has lost its value in each increasing amount-diminishing marginal returns to his satisfaction, if you will. So he will need more and more to make him as happy as the first unit of wealth had. If there is an outside check on this "need", he will be forced to stop (IE, the government, or cultural ethical standards). Otherwise, in order to feed this desire, he will perhaps appoint his friends to the board of executives who will allow his income to reach exorbinant amounts (I owe part of this analogy to Paul Krugman). The other people of the group will try to get where he is, by taking out massive credit card debt. Perhaps the rich guy will realize that he can loan these people money and then charge them extraodinary amounts of interest. There is more than a little validity to this statement. Indeed, the interest rates for credit cards versus the interest rates that banks pay has been widening substantially. Banks will make a profit, therefore, off of consumer debt, and consumer debt will further push lendees into poverty.

What of these cultural standards? Are they particularly important? Research at the University of Colorado has conducted experiments with morality and income distribution that seem to suggest that cultural morals are important in this discussion. Candidates from Russia, China, and the United States were asked to participate. The criteria was that one person of the group would receive a larger monetary gain than the others. The group could vote against or for this gain. A vote was conducted knowing which person will receive the gain, and a vote unknowing who the gain would go to. Post-soviet or post-Communist states tended to vote against the gain, even if they had a chance of receiving it; while people in America were more likely to vote for the gain, even if they knew who would receive it. It is sometimes reported in the news that in Russia, one person will sabotage another's house or belongings if that person has received a monetary gain above that which is deemed acceptable.

Income inequality, as I touched on earlier, is not a fluke. It did not happen due to a natural relationship. It occured out of human greed and a deliberate manipulation from a few influential and already wealthy people of the majority of the population. In Michael Parenti's book, "Culture Struggle", he notes the socio-cultural trend towards rugged individualism, the concept that we are each responsible for our own destiny. Hyper-individualism, which has been a wealthy hipster trend of practicing Yoga, Buddhism and meditation, is great for peace of mind of the individual, but allows the individual to blame each person's problems on their own state of mind. When a family is living in poverty, it may be difficult to convince yourself you and your children are not starving. Brad DeLong, in his August 10, 2008 blog, discussed inequality as a result partially by the government, but not completely. He reasonably stated that the government mostly controlled after-tax inequality, not pre-taxation inequality. A good point, I think. I do think there are other ways to lower wage incomes than taxation-- something that the government has much control over, such as exclusionary public services and barriers to unionization. Certainly, there exists no single answer for this problem, and several interconnected trends are reciprocally enforcing one another.

Any insight is welcome.

Monday, December 15, 2008

Income Inequality in America

First, I enjoy Paul Krugman's theories on income inequality in the United States. He cites one of the proximate causes for this trend as an increasingly individualistic-centered political sphere. To be clear, the notion of more limited government and the rugged individualism ideals which promoted private gain and social indifference exceeded a mindset of the government aiding its citizens and equalizing living conditions. Political and social environments thus metamorphasized from a post-depression era compression of income inequalities into an incredible disparity between the lowest and highest incomes in the United States.

The "skilled-biased technological change" argument has some validity, though I find it more or less a cop-out argument, which doesn't relate to the central problem of widening incomes. For instance, it's as if you are reasoning that the reason why someone would punch another person in the face is because they are angry. Yes, but why are they angry? Weird analogy, but it's workable. Skilled-biased technological change, for less nerdy economic gurus than myself, is the idea that as a country's exports and production move towards an industry with a higher skill level, the demand for this industry will shift outward and will require more workers with higher wages. This will in turn release workers from the lower skilled sectors, and push the demand for labor in these sectors down, along with their wages. With the relatively rapid advancement of technology over the past few decades and a shift towards a higher demand for information technology, it seems like this is more or less completely the case. It is also the reason why many Americans say that Mexican immigrants are depressing their wages. True as it may be, nobody seems to ask what is causing these movements, and why some people get left behind and others get magnificently rewarded. Could they just be lucky? Perhaps, suggests Krugman, it is a financial sector that has been able to loosen moral standards over the past couple of decades in order to gain higher incomes for themselves, which they argue they deserve--such as hedge fund managers, financial analysts, etc.

Again, what is causing this? Why is it that some people have the right skills at the right time and others do not? The American notion that individual prosperity rests on the individual leaves many behind that cannot afford to be left behind. The only problem with this is, that as more and more people get left on the bottom to eat the richs' leftovers and die on the richs' streets, the greater portion of the population will be engulfed by this percentage. It is not sustainable. It never has been, and I find it difficult to believe that it will continue. What needs to change is the political atmosphere of corporate elitism, not the skills that the population possesses. It is a cause of this problem, and not an effect. As power and the density economic wealth concentrates, to the degree that it concentrates, this pattern perpetuates, and creates trends which will continue the concentration of power. It is in their best interest to do so, if they are given the chance to further nurse their greed and need for control. Nothing is checking these people-- and though I hope that their mindset is a unique one, and not of the majority of the world's population, their actions are incredibly pervasive, as well as destructive.

I will be posting more on income inequality and notable economists' opinions on the concentration of prosperity soon-- if you have anything to say, please do so.

Monday, October 13, 2008

Human Economics in Bhutan

Listening to NPR yesterday, I heard a very interesting short segment on happiness derived from wealth; something I take personal opinion to as being relatively unrelated. (Read: As most commodities, wealth seems to have diminishing marginal returns. That is, as wealth increases, the satisfaction derived from each additional unit tends to decrease. It becomes harder to become marginally happier as we get richer. Make sense? Of course it does. Unfortunately, most standard measurements of implicit happiness in countries is GDP-- a country's income. It is assumed that as standards of living increase, and people become marginally more well-off financially, their happiness will increase continually as well. This is not true, logically as well as scientifically.

Perhaps if someone has very little wealth, an increase in income will decrease the burden of taking care of a family, paying bills, paying rent or a mortgage, whatever. This will be very noticeable when this person's income is increasing from very little to begin with. After a certain point, though, it will have little or no effect on happiness. Human beings are social creatures, and need human interaction to lead content and satisfied lives. Money has a little to do with happiness, but is vastly overestimated. The country Bhutan started a Gross International Happiness Program, based on Buddhist principles, in which GDP is not a fair measure of well-being of a country's citizens. Bhutan has attempted to isolate itself from the effects of globalization and international trade. Over recent years, this has proved to be somewhat impossible and perhaps as a result, the Gross Happiness Index has fallen.

Interesting concept, don't you think?

"Increases in income are matched by increases in aspirations for income. And the net effect is no change in happiness."-Prof. Richard Easterlin; happiness economist.

Why Bono is doing more harm than good for Africa

For somewhat ridiculous reasons, I got to thinking a lot about international aid-- in particular the celebrity endorsement of completely ineffective policies in an effort to "help" Africa. For the purposes of my own argument (and because his music is awful) I single out Bono. This is fair, in my opinion, to counter the absurd amounts of praise this man receives for promoting the mass consumption of consumer goods like iPods, increasing the sale of his records by painting himself as a hero, and most importantly, diverting very scarce amounts of money, knowledge, and willing hands away from significant problems in order to focus on what is most popular.

The very notion that the West is the only way Africa may be saved is underhandedly racist and insulting. Though we may like to believe we have come a long way from believing colonization was simply "saving" uncivilized Africans, we have truly only shifted our haughtiness to a new line of rhetoric- Africa is in ruin and we must sweep in and save the continent as only we can. There is no stastical link between throwing money at nations and economic growth or disease control. In fact, the policies that have been used have worked so horribly, they have arguably contributed to a negative growth rate, perpetuation of corrupt institutions, and growth of disease. Funny, then, that the IMF, the World Bank, and the alphabet soup of aid organizations continues in this direction. You may say we don't know-- and you would be correct. There are little efforts to ask those affected by these policies if the problem to be addressed is getting better. There is zero accountability.

The far-reaching, utopian ideas spout out by Jeffrey Sachs and Bono are quite attractive. Unfortunately, without accountability and feedback (paraphrasing from Easterly's book) we have no way to see what needs to be done and what is most effective. It is interesting that people have tended to gravitate towards speaking out against worldwide calamities only when they become severe and difficult to address. The outbreak of AIDS, for instance, was well predicted by the international community as early as the 1980s. Where were prevention programs, why wasn't Bono inspiring others to support sex education in Africa? Instead, it was ignored, implying that, although the problem was known and preventable, we decided to let it happen anyways. Perhaps there is more implied racism in the Western aid's actions than its self-proclaimed purpose. Revealed preference theory in economics aligns perfectly with this idea. Here is a concise definition of this very simplistic idea from"This is the notion that what you want is revealed by what you do, not by what you say. Actions speak louder than words."

Anyways, the most important non-contribution to relief efforts has been diverting resources away from what is most important. If you truly care about who you are trying to help, despite their nationality, cries from celebrities, and your own past failures-- you will place what you have in what will help the most amount of people in the quickest amount of time. When we prolong the life of an AIDS victim one more year, we divert at least $1500 away from other problems. Vaccines to prevent much wider-spread diseases (malaria, diarrhea, etc.) sometimes cost pennies and can save thousands of lives at the cost of prolonging someone's life an additional year. These diseases kill 2.5 times more people than AIDS, but cost much less to prevent and to treat. It seems cruel to say that we are effectually killing people by giving money instead to people already infected with AIDS, but from a simple tradeoff approach, it is true.

Africa's poor does not need our pity, does not need our aid dollars spent on what "we" think is best for them. My dislike for Bono is simply due to his extremely loud presence and the focus of his message to be increasing the amount of aid poured into countries, rather than its effectiveness. It is easy to say that you are concerned with the world's poor and suffering. Most people stop at that, and are not concerned with whether or not our interference is helping those we are supposedly intending to help. As long as we are doing something, right? Anything? The West is, again, effectually hurting Africa much more than it is helping; while it can sleep at night thinking it is the hero, the savior, of those it is convinced cannot help themselves. History repeats itself in interesting ways, and it is even more fascinating why it is never realized.

If you're as interested as I in this topic, I highly recommend William Easterly's The Elusive Quest for Growth and The White Man's Burden: Why the West's Efforts to Aid the Rest Have Done So Much Ill and So Little Good; as well as Paul Collier's Bottom Billion.

Paul Krugman wins Nobel Prize!

In case you're interested (as I certainly am), Paul Krugman-- professor at Princeton University, op-ed writer for the New York Times, and a well-respected member of the economics community, won the Nobel Prize in economics. Quite deservably, if you ask me!
From the NY Times, today:

Honoring Paul Krugman
Edward L. Glaeser
Edward L. Glaeser is an economist at Harvard.

Rarely, if ever, has an economics Nobel laureate been as widely known before receiving the prize than Paul Krugman. His New York Times columns have been read by millions; he has argued economic policy eloquently in a large number of popular books. Yet these pursuits had little to do with the decision of the Nobel committee. They gave this prize to honor a truly seminal figure in economic trade and geography. Mr. Krugman’s fame as a public intellectual should not lead anyone to think that they understand his contributions to economic research just because they regularly read his columns.
The Nobel Prize citation highlights two distinct but connected contributions: Mr. Krugman’s development of the “new trade theory” and his work on the “new economic geography.” International trade has a long history in economics, and for the bulk of the field’s history, patterns of trade have been explained by factor endowments and comparative advantage. Why does England export wool and Portugal export wine? The cold winters of Yorkshire produce really fluffy sheep and the banks of the Douro produce splendid grapes. Yet comparative advantage does little to explain much of modern international trade, especially not trade within industries.
Mr. Krugman published two seminal papers in 1979 and 1980 that made sense of the fact that Toyota sells cars in Germany and Mercedes-Benz sells cars in Japan. Mr. Krugman started with a variant of Edward Chamberlain’s model of monopolistic competition. In this model, every firm sells a slightly different good — an Infiniti is not exactly the same thing as a BMW. There are fixed costs of production, which means that producers get more efficient as they sell more. Finally, consumers like variety, so that even if they live in the Land of the Rising Sun, with its abundant well-made cars, they still occasionally want something a little more Teutonic.
These ingredients came together and provided a framework than can match the world’s trade patterns better than the 19th-century framework of David Ricardo, or the mid-20th-century models of Eli Heckscher, Bertil Ohlin and Paul Samuelson. The fact that two out of three of those 20th-century giants are themselves Swedes should remind us of how seriously the Swedes take their trade theory, and what a big deal it is for them to admit Mr. Krugman to the pantheon.
Mr. Krugman’s trade models became the standard in the economics profession both because they fit the world a bit better and because they were masterpieces of mathematical modeling. His models’ combination of realism, elegance and tractability meant that they could provide the underpinnings for thousands of subsequent papers on trade, economic growth, political economy and especially economic geography.
Mr. Krugman’s 1991 Journal of Political Economy paper, “Increasing Returns and Economic Geography,” is the first article that provides a clear, internally consistent mathematically rigorous framework for thinking simultaneously about trade and the location of people and firms across space. It is one of only two models that I insist that Harvard’s Ph.D. students in urban economics be able to regurgitate, equation by equation.
The model begins with the same basic elements as the new trade theory: monopolistic competition, scale economics, love of variety. To these elements Mr. Krugman adds free migration of workers across space and industries. Because workers are able to move, real wages equalize across space. People in New York City may be paid more, but they give some of that back in the form of higher housing prices. The paper provides economists with a clear framework that can make sense of where we all live. Firms and workers are pulled toward the same location to reduce transportation costs of shipping goods. For example, the garment industry located in New York City, in part because of the vast trade in textiles that was already moving through the city and because of the large number of customers already living in America’s largest city.
Of course, we don’t all live in the same city. A good model of geography needs both a centripetal and a centrifugal force. In Mr. Krugman’s model, populations are pulled apart by the desire to be close to natural inputs, like land or coal mines. Cyrus McCormick moved his reaper business from Virginia to Chicago to be closer to his rural customers in the Midwest. Later models incorporated traffic congestion and other forces that limit the growth of a single large urban area. Mr. Krugman’s model proved to quite adaptable; it has received thousands of citations.
In his public role, Paul Krugman is often a polarizing figure, loved by millions but also intensely disliked by his political opponents. I still chuckle over an old New Yorker cartoon with one plutocrat saying to another that he gets some satisfaction from the fact that his vote will cancel out the vote of Paul Krugman. Within the less divided world of the academy, Mr. Krugman’s economic research has generated plenty of light, but far less heat. His papers are universally acknowledged to be immense contributions that helped to create two distinct fields. His Nobel Prize is extremely well deserved and not unexpected. I, for one, had bet on him in Harvard’s Nobel Prize winner pool.

Saturday, September 20, 2008

Hoover versus McCain

Thank you, Paul Krugman, for pointing out an interesting coincidence.

Herbert Hoover, Oct. 25, 1929: "The fundamental of business is sound."

John McCain, September 16, 2008: "The fundamentals of our economy are strong."

Time to pay for deregulation. We'll just blame Alan Greenspan for this one, just like all the other flaws of an economy. After all, being Fed chairman gives you sole power of the immediate and long-run health of the economy. Right? Excuse my sarcasm, but I hate scapegoating. Particularly if it is Alan Greenspan, a man I give much respect to.

President Bush announced with Treasury Secretary Henry Paulson, a proposal to buy up highly leveraged investment banks, hoping to add liquidity to the markets. Unfortunately, this seems to me like putting a bandaid on the problem and offering incentives for banks to increase risk in the future. Not to mention the bad money that is being created to buy these banks, probably at a cost that is above what they are worth, placing the burden on taxpayers. we'll see what happens, but I have a bad feeling about the prospects of government taking over bad assets with taxpayer money.

Tuesday, September 9, 2008

Abusurdity in the World of Aid

Though my faith in international aid organizations was weak at best to begin with, I think it has reached a new low. The International Monetary Fund and what would become the World Bank never intended to be lasting institutions. They were created for the sole purpose of establishing order in the international financial world that had been in chaos because of the war. Power was vested in the victors of the war, mainly the United States and to a smaller extent England. Countries who lost the war were given much lesser power, and those without any financial clout were ignored entirely. These were temporary organizations. And temporary organizations, particularly when created for the sake of security, allow those in control to act above what is normally acceptable. In times of war and fear of war, this is also very prevalent.

My concern isn't entirely with the foundations of these organizations. My concern is the way that they are handled today. As the gap between the world's poor and rich thickens, it becomes easier to distance oneself from the deprivation of the third world, living in a relatively excessively rich country as the United States. And it is easy to say that we are doing all we can--that it is up to the governments to respond-- perhaps, according to a quasi-racist remark in a university classroom-- it is simply their culture, assuming that they are happily starving and dying of disease because they hold onto a particular ancestry. I find that difficult to believe. It reminds me of a dehumanization process that people allow themselves to undergo when they are at war, or they want to justify the murder or oppression of large groups of people. It is also difficult for me to believe that, for example, Africans' culture has made their poverty, and not the blundering, raping, and divisiveness of European colonization.

In any case, as an economics student, I have been conditioned to believe that people are selfish. And I do agree with this. I believe that any benevolent act-- regardless of its positive effect or perceived kindness, has a selfish intention. Even if this is to make a person feel better about their own soul, whatever it may be, people have little to offer others besides their self-interest. And this can be managed! That's the best part. Adam Smith, though preceded by similar thinkers, was the loudest voice of the utilization of self-interest to the betterment of society. And this is possible, (why not?) on a global scale the same as it applies to closed economies. In fact, I believe it would be even more effective. The important point to keep in mind is that a global organization must align people's incentives with goals of world development and growth, particularly for third and second world countries. The IMF and the World Bank have the power to do this. But instead, they arbitrarily give loans to countries who cannot pay them back. And these organizations indirectly make sure that they will never pay back these loans by allowing recipient country's governments to have a constant and perpetual cushion of aid.

William Easterly's point in The Elusive Quest for Growth--which I highly recommend-- is that the appearance of helping developing countries is far more important than the actual benefit given to these countries. This could explain why there is little emphasis put on asking the poor what they need. The not-so-underlying assumption is that we know better than they do, while our half-hearted efforts to help have unquestionably failed. Before I get too carried away, I want to say that a large part of this failure is also failed economic theories of growth. The World Bank and the IMF still cling to the theory that investment will automatically trigger growth--that there is a so-called financing gap between the savings potential of a country and the investment potential of a country. This is an attractive theory. It must have been, for those in international aid organizations to cling with such undying fervor. That's a beautiful thing, when the theory hasn't been proven wrong over and over throughout the past century.

The key to growth, according to Robert Solow (read Growth Theory: An Exposition) is technology. Investment is only about a third of the causation behind growth. The problem is, that aid organizations dump funds, theoretically, for investment-- though most or all of it goes to immediate consumption-- and this leads to zero growth. Even with high investment, countries cannot grow because they are missing 2/3 of their growth recipe. This 2/3, according to Solow, is contributed to technology. Unfortunately, access to technological change is not available in many countries with already slow or even negative growth rates.

It's a shame that the IMF and World Bank do not acknowledge a different theory of growth besides outdated and evidently wrong theories. Although it is very easy to continue business as usual, particularly when it looks so good. Treatment of AIDS, for example, looks much more admirable than prevention. Prevention involves birth control and family planning-- which have most definitely been pushed aside by the Bush administration, if not the rest of the world. Unfortunately, what we are dealing with is not numbers and data and theories. It is the lives and suffering of people who do NOT have what you have, and do NOT know what it is like to always have food and always have a safe place to go to sleep at night. It may sound clicheed, but it shouldn't. It should give you chills. It should make you want to do something, to be outraged. At the very least, be the most grateful you can possibly be if your situation is better than most of the world's, and you never have to worry about your children starving in front of you.

Friday, June 13, 2008

The value of human life

I suppose I'm more of a wannabe economist than an actual economist, however, I do understand the science more than the average person. I realize this doesn't say much, either. One thing that has always startled me, intrigued me--the value that people inadvertently place on human life. It is unappealing to do so, but it is done all the time. The families of the victims of 9/11 were compensated based on their loss. The value of that loss would, in rough economics terms--be equal to the amount of satisfaction given to the family members had this person stayed alive. This is only according to the government, however, which I can say for certain is not a good judge for morality. I am almost certain that the family members would be less likely to place an equal monetary value on their loved one's life.

A brief article in Time suggested that economists were attempting to place a value of human life for kidney research, placing the value at 126,000 USD. This is amazing to me. Where they derive this number, I'm not sure, but on first glance, it seems as though it is completely arbitrary and incredulous. However, perhaps the average person is worth more than $126,000.00 (to whom it doesn't say)--based on what they contribute and consume in their average lifetime. This "average" person will also have negative impacts on his or her environment, for example. When the positive and negative contributions are calculated, perhaps one can put a monetary value on it.

As revolting as this may seem to you, no matter what value you place on human life--whether it be 99 million--it will always be equal to another commodity, such as 99 million orders of french fries from McDonalds. And, if the value of human life truly is that high--which to our government I assure you it is not-- then the government, theoretically run by rational men and women, would weigh the value of human life with issues such as health care, war, and the wrongful death penalty convictions. If the value of life was in fact 99 million, what could the benefits possibly be from war that would compensate for this loss?

This leads me to believe that perhaps there are personal gains from the indirect, or direct, loss of life that exceed the individual reaps. It is difficult for people to be rational unless they are trying to benefit themselves the best they possibly can. This is terrifying. The government is not made up of worldly, selfless individuals. It is made up of people who are constantly trying to maximize their gains, just like the rest of the population, but these are the people that make huge, important decisions. Doesn't that worry you?

Saturday, May 31, 2008

Suspending gas tax=Bad

I love that politicians will say whatever rhetoric they imagine will make voters support them. As if people will start pissing themselves in sheer joy when they are told that they do not have to pay a gas tax for a couple of months, run to the polls, and confess their undying support. John McCain (and Hillary Clinton, though less vocally)-- believe it or not, does not have another reason to suggest levying the tax than for gaining support where he seems to be lacking it.

Any economist can tell you that suspending the gasoline tax would be counterproductive to the economy, the environment, and may even help corporations. Gasoline is a fairly inelastic good, for now; until some kind of reliable and inexpensive substitute is introduced. Even so, when the price of gasoline is lowered; eliminating the excise tax of 18.4 cents per gallon, the demand for gasoline will be higher, people will buy more gasoline, and consume more of it. Because of this increased consumption, will the price of gasoline actually increase? Basic supply and demand tells us yes. Even if it does not dramatically increase the price of gasoline, the prices will remain relatively high because of its demand, and any trends in gasoline prices will continue after the tax is reinstated. Gasoline will NOT go down in prices, for as long as we continue to have a universal demand. As the supply decreases, there is no other way for prices to go but up. Corporations will therefore be generating higher profits; their costs to produce will be exactly the same (they don't have to pay any of the tax) but their demand for gasoline will be artificially higher, and they will sell more. Good for them! Even the basic argument is flawed; you cannot help the poor by decreasing the prices of goods; it is usually ineffective. The government should focus on raising the incomes of the poor, rather than temporarily and minimally reducing the burden of an 18.4 cent gas tax.

Adam Smith would tell us that the price of gasoline is so high because that is what people demand, and I believe that is correct. When you arbitrarily lower prices, you are working outside the market and forcing a shortage, which in turn creates a higher demand and higher prices. In a "free" market, there is no room for price-fixing, it is always ineffective and sometimes destructive to the economy at large. Erasing the satisfaction generated by public goods from the gas tax, when factored in, would hardly be compensated by the satisfaction of an ordinary person saving 18.4 cents per gallon, to ALL consumers of gasoline despite their income level.

The absurdity of this program sticks out not only to me--and I can barely comprehend what else would be in store for the economy should McCain be elected. Republicans, if you ask me, are steering far away from the free market capitalism that they are "supposed" to support. Their history of fixing prices and bigger government hinders a free market and makes it impossible to allocate resources effectively.

Thursday, April 24, 2008

Microfinance and Women

While poverty has swept the world with its innumerable causes, women have felt a majority of the effects. Seven out of ten of the poorest people in the world are women (Feinstein). The gender gap that exists in third world countries or least developed countries (LDCs) has significantly affected the entire economy and development of these countries. With the introduction of microcredit, a program innovated first in Bangladesh, families and particularly women have been able to break some of the barriers to producing income and cash flow. Though a relatively new idea, the programs have been so successful that they have expanded to approximately 70 countries and 100 million families, including those in the first world (Murali and Padmanaban). The idea of microcredit must be expanded and differentiated in order to appropriately address the needs of the people of each country. The potential for microcredit to empower women and help them achieve economic success of their own is great, with the assistance of governments and possible changes in the institutional structures within the countries.

Countries that experience less economic opportunity than others have several contributing factors. On the supply side of development, there may be impediments to free trade and international exchange—such as tariffs, quotas, voluntary export restraints, barriers to intellectual property rights, and export subsidies in other countries.There may also be causes such as natural disasters, war, and economic sanctions against a particular country that make it difficult or practically impossible to develop economically. The functional infrastructure of the country will also significantly affect the country’s ability to develop. The natural business cycles of the world economy and of the business within the country will affect the country’s economic health. If the country has a natural resource abundancy and is specializing in the production of natural resources or agricultural goods for production, they may also be affected by changes in the natural weather patterns and trends.

However, families are equally affected by demand side factors of development, such as the lack of skills, training, education, and literacy- all of which expand an individual’s human capital and therefore income potential. The lack of purchasing power based on the inability to create a steady stream of income will impede the individual to participate in the marketplace. Similarly, individuals and families need capital and assets, which comes from the ability to save and borrow money (Feinstein).

The causes for women’s impoverishment are directly related to these general causes of poverty. Generally, if employment is available, the jobs will go to the men first and foremost (Murali and Padmanaban). Societal discrimination will determine the roles that men and women play- and will affect the ways in which they obtain income as well. Through different cultural standards, women may be expected to not play a part in the income-making process. In many developing countries, society demands that women are responsible for nonmarket work inside of the household and are subordinate to men. Regional differences may also contribute to whether women have income-making opportunities or not. For example, a woman in a more urban area will find it easier to break the societal norms and find employment than a rural town where women continue to live by the laws of their community and are less in touch with the rest of the world. Women have a difficult time breaking into the work force in developing and developed countries because of their lack of role models and established networks in the employment fields (Kay). A woman would be reluctant to train for and pursue an occupation in which men are the dominant force behind, as men would likewise be reluctant to train a woman for their particular field and increase competition against them while going against societal norms.

Perhaps also, the work that is available is more geared to a certain gender. If there is only difficult, manual labor available, there will be less demand for women because men are seen to be comparatively better at physical labor than women. The availability of banking institutions for women will greatly decrease their economic power and their ability to make income. People in first world countries depend on financial institutions to save and borrow money- whether for inside the household or for starting and maintaining a business. When these tools are taken away from a particular group of people, they will feel the economic consequences.

Consider Bangladesh-- amidst a horrible famine in 1976. Muhammad Yunus, an economics professor at Chittagong University, was observing people trying to survive throughout this time and noticed a woman with three children making bamboo stools for a living. He loaned her a small amount of money in an experiment to see what might happen. To his surprise, she paid it back in full along with several other people he loaned money to in the same fashion. The people he loaned money to were able to invest in their business and make considerably higher profits, as well as having the ability to pay back the loan. Yunus began to work with local banks and then started the Grameen Bank. The bank would eventually grow to South America, Africa, Asia, and the United States. Repayment of loans from the Grameen Bank is at 98.4%, much higher than commercial banks, and loans are given without collateral most times. The Grameen Bank is geared towards offering loans to women: 97% of the 7.31 million borrowers are women (Yunus).

The Grameen Bank and the microcredit movement have been designed specifically for women and their potential for developing the third world, as well as impoverished areas of developed countries. Indeed, the idea of development without the use of an entire half of the population is absurd and irrational. However, these programs work extremely well with women because of the way that the groups function and are designed. A case study of Rotating Savings and Credit Associations (ROSCAs)—essentially microcredit programs—in the town of Karatina in Central Kenya displays a number of different reasons why women would be preferable to men for microcredit programs (Johnson).

Women tend to repay loans more reliably because of the social shame of no repayment of the loan. Loans are given through a group of women that are collectively responsible for the repayment of all of their loans. If one of the group members fails to pay back a loan, the other women are responsible for splitting the cost of the loans or being cut off from the loan institution (Johnson). One woman in the Karatina study explained that it was “… Embarrassing to go to a gitati [microcredit group] without money… You are going to spoil your name and people will be fearing you—seeing you as someone who doesn’t pay”. This creates substantial pressure for women to repay their loans, fearing the disappointment of the entire group. Women tend to work better in social networks together than men, and tend to take out smaller quantities and lower amounts of loans than men, making them more desirable to creditors. Many women also prefer single-sex ROSCAs as they are able to work more efficiently with women and they are able to save their money without informing their husbands (Chester and Kuhn).

Microcredit programs tend to be less effective for men because men behave in a different manner in groups. Many of the groups attempted with men have failed. On a number of occasions, physical violence has broken out between members of the group. The men felt subordinated by the rules of the loans and the strictness of attending meetings. In addition, they acted in a more competitive way, keeping problems to themselves and maintaining a level of mistrust between one another. As one man in Kenya explained, “Men are proud and do not trust each other. Every man is clever. You know someone is going to mess you up” (Johnson).

Apart from these reasons, women are a better investment because their social returns have such a higher potential. Women do not have access to loans that men might have, so it is more reasonable to invest in women.

With the ability to obtain capital and invest, women and entire countries have noticed the effects of lending money to women. Most of the effects are evident in LDCs but developed countries have also used microfinance programs and seen success from their programs. There have been some negative effects that have been noted and analyzed by journalists and economists that must also be addressed.

The most obvious result of these small loans is the ability for women to make their own income. Previously, men were the sole bread winners in many of the economies where microcredit is used. For example, women in Jdeideh, Jordan from an impoverished mountainside village grossed $500,000 in 1994 weaving rugs and selling them. This provided a livable wage for as many as 1,600 workers who were involved in the project (Glain). With this improved income, many women were able to purchase more and more of a decisive voice in the purchases of the family. The bargaining power of women is greatly increased when they are creating their own income—that is, they have more of a say in the way that money is spent within the household. Men who were working more than one job were sometimes able to quit one of their jobs. As men were the sole breadwinners, there was now less to support their families when another income-producer was contributing to the family income. Women are also found to spend their money more on their children (Goetz and Gupta) and will therefore change the structure of what is supplied and demanded in these countries. Women enrolled their children in school between 47% and 61% more with a 10% increase in borrowing (Khandker). Children therefore will have a greater chance for education and will continue to develop the economy with their increased human capital due to this education. Women also tend to encourage their daughters more in education than men will, perhaps causing a decreased gender gap within education and therefore earnings (Kabeen). The total income of the family is undeniably improved, and the consumption equilibrium of the family would shift, demonstrating a greater overall satisfaction (Goetz and Gupta). The community would experience a greater income as well, with so many of its families participating in the loan programs which would increase their income.

The community and the family would theoretically have more income to invest in sanitation, nutrition, health insurance, savings, and education. The community would advance its culture by the specialization of particular trades of the micro-businesses. Take, for example, the Bani Hamida’s Women’s Weaving Project, which utilized ancient rug-making techniques and developed these skills within the community. The weaving of these rugs had been on its last years, but was revived by the employment of this program (Glain).

The societal standing of women has found itself to change when women are perceived to have greater value based on their success. Women felt included in the community, as before the credit, women felt outside of the “orbit of community life” and “excluded from its social events and from everyday forms of hospitality” (Simanowitz and Walker). One woman, when asked if her situation has gotten worse or better since she took out a microloan, replied, “Have things improved for us? Listen, when you have no money, there is nobody, but when you ave money, you suddenly have so many friends and acquaintances. Money is all. All that time, when we had no food, nothing to neat, no one wanted to give us anything” (Kabeen).

This perceived increase in value also helped women within their families. Family members and husbands felt a greater affection towards women that were successful in these programs, and there was less financial tension between the husband and wife. Women feel more self-worth and empowerment through having the opportunity to create a business or be part of something that was creating income. Women feel good about being able to help out their families and being able to be self-sufficient in case anything happened with their family or husband. Many women chose to open their own savings accounts and life insurance plans for this reason. Although divorce is still socially unacceptable in many developing countries, women have the opportunity with their own income to create a “divorce within the marriage”, that is, to separate all of the finances within the marriage so that each person is independent of on another (Johnson). Though studies on domestic abuse conflict, many find that violence is decreased with the introduction of the woman’s income. Perhaps this is because of the alleviation of the pressure on men to be the only breadwinners, or because of the increased value that the woman is given with her own income.

Sometimes the microcredit programs fall short, however of what they intend to accomplish. For example, microcredit works on a demand-side argument that hopes that working with individuals will help the economy of the country as a whole. However, very often this is not the case. Microcredit cannot change the societal institutions that support gender discrimination. In order for women to be liberated within the market, larger institutional changes need to take place. Though credit is important for development, many argue that it will not solve poverty or will empower women alone (Feiner). Even the loans may not empower women as much as they seem to. Many loans are co-signed by a male, usually a husband, or are controlled secretly or overtly by the husband. Therefore, loans are not truly empowering women, but are only placing more control in the hands of the men of the country.

In addition, because the Grameen Bank and similar microcredit banks earn profit, they may be said to have interests that do not coincide with the impoverished—many argue that the interest rates that these banks charge are usurping the poor. Although a counterargument points out that because the Grameen Bank borrows from other sources, the interest rate adds up and the final amount that is being borrowed covers this cost as well as the cost of administering a large number of small loans. The banks can, however, use microcredit to their own advantage and there is the opportunity for maximizing their own utility rather than the utility of the poor. Sometimes the power of microcredit can be misused, as well.

In Beirut, Lebanon, an intelligent economist and world-branded terrorist Hussein al-Shami uses microcredit programs to develop the funds of the Hezbollah group. Hezbollah is named a terrorist organization by the United States because of their supposed connection to violent terrorist acts. These microcredit loans are also given to women but do not encourage their empowerment by the nature of the organization (Higgins).

As the study of the Jordanian women weaving rugs addressed, sometimes the free market is a cruel force and can put a project out of business just as easily as it had given the project success. Women will put their hard work into the business and may not receive economic benefit to their labor. In the case of the Jordanian weaving project, the women were so successful that they attracted fierce competition that would utilize cheap labor from Egypt in order to drive down their prices. Many other groups were funded by international aid organizations for the same purpose of economic development. The women who began the project were unable to lower their prices and the demand for their products dropped significantly. One woman explained, “It was so hard to compete. We had to do everything by hand. It’s like having the government in the market, and the NGO is the government” (Glain).

In first word countries, the effects of microcredit programs are very different. The only two Grameen-affiliated programs in the United States are located in Dallas and Harlem. Though these programs have had a successful experience, it is a difficult process for one to receive a loan—including classes and strict rules. Those that make it through this process have found success in their new businesses. Veronica Rivera, a woman from Mexico City, was enrolled in the Dallas microfinance program- called the PLAN fund. She began her own janitorial company and is now grossing $100,000 a year. The program has helped her understand the intricacies of owning a business, such as taxes and payroll accounts (Hall). Though this is a very different account from the developing world, these microfinance programs seem to have a positive effect, particularly on women, even in developed countries.

Similarly, banking designed specifically for women, has become a recent trend in developed countries. In the United Kingdom and Germany, bankers have realized that women are an enormous customer group, and it would be unreasonable to ignore them. The Raiffeisenbank Gastein in Germany has reached many women looking for banking for managing household finances or managing their businesses. In the UK, the private bank Coutts has been attempting to attract more women to its business. Indeed, a 2006 Centre for Economic Business Research study predicts that 53% of millionaires in 2020 will be women. The report also estimates that there are 448,000 women currently in the UK who are classified as being of “high net worth”. The banks support female entrepreneurship and empowerment of women through control of their financial services. Supporting women’s economic development also leads to greater gains in the country’s economic welfare, even when considering first word countries. In Canada, women’s self-employment grew 43% in the last ten years, and has contributed to approximately $18 billion dollars to Canada’s economic growth (Odoi). Lending banking services to women and encouraging self-employment among women is lucrative for banks, is empowering to women, and is effective for encouraging growth in the entire economy.

Case studies worldwide have come up with success stories concerning the microcredit programs and their ability to advance the social and economic status of women. In the Niger Delta, for example, the United Nations Development Fund for Women has joined forces with Micro Credit Finance Institutions in the region to encourage entrepreneurship and to give the women of the area capital that they can start businesses with. The training that they have been able to receive gives the women valuable computer skills and management skills—as well as naturally organizing the women into cooperatives. The program has been so successful that identical projects are finding themselves implemented in other parts of the state (Ilbom).

In the mostly Muslim area of Narathiawat in south Thailand, the effects of female entrepreneurship have truly shown what microcredit can do for the individual woman, women in groups, and women advancing their communities. Several groups were started to produce certain products, such as embroidery. Funds were given to each group and the women have successfully marketed and sold their products. With this growth, women have been able to be more in touch with the world around them through computer technology and from trading with nearby regions. According to the study that was conducted regarding these groups, the women were more empowered within their household to be major decision-makers. Many women also went on to work with the structure of the community and address certain political issues they found relevant during their entrepreneurship (Kay).

Perhaps the most successful of countries for advancing women through microcredit is India. A case study in Haveli Tauka in western India reports that 3000 women were given the chance to utilize small loans for their development. The program was successful and women reported income through activities such as goat rearing, jewelry making, and farming and vegetable cultivation. According to the article, “the poorest of the poor have been helped to break the barrier of poverty and gain economic independence” (Fernandes). Along with the loans, the women have been given training in empowerment and “capacity building”—setting unlimited goals for women and their advancement.

Where the idea for microcredit began is also an excellent example of how it has helped women. The country of Bangladesh uses small loans to provide credit to the rural areas of the country. Groups have been so successful in this country because people can choose which groups they would like to work with and can have support and guidance through these groups. Groups also make the repayment rate very high—for the Grameen Bank, women recovered loans at 99.4% in 1994. This is unheard of in commercial banking institutions. Though the societal standards looking down upon women who leave their households for work in the labor market have not changed significantly, women can achieve income of their own working in the household and not forgoing nonmarket work. Women’s nonland assets increased 2% for each labor hour worked, with a 10% increase in borrowing from the Grameen Bank. Credit given to men in this study does not have any impact on their purchasing power or their advancement.

Women have the potential for incredible economic growth through microcredit programs. Though these programs are not substantial enough to lift women and countries out of poverty alone, they are a brilliant idea for helping to ease the pain of the impoverished. Banking services are essential for economic growth and need to be available for all people- especially women in developing countries. Microcredit programs must be designed differently for women in third and first world countries. The programs must change according to each country’s specific needs and development goals.

Adam Smith's Dynamic Equilibrium

Adam Smith’s intention in writing An Inquiry into the Nature and Causes of the Wealth of Nations was to explain the accumulation and definition of wealth of a society. In doing so, Smith described a liberated economic system in which a society could maintain internal balance while constantly changing and moving towards equilibrium and perfect justice. Smith’s portrait of a relatively stable economy would also have the tendency to grow its wealth and productivity.

Smith did not have the original idea of a self-maintaining society, but rather gave a clear voice to the concept of harnessing the power of a marketplace and of individual’s self interest to continually move toward this goal. The ancient Greek philosophers described an ideal state—of social and economic equilibria. This would be achieved through, for example, Plato’s caste system in which all occupations were decided at birth—a socially immobile division of labor. However, Plato’s system implies that men are naturally better or worse because of a preposition to a particular trade. Adam Smith’s ideal state gives more equality to the abilities of man, as most differences are developed through culture and education. The Greeks also held the belief that self interest was contrary to economic growth. Aristotle desired a system where a just price would be maintained through honesty of the purchaser and seller, not of their self-love. Similarly, the Mercantilists believed that self-interest was destructive to the wealth of the nation—for example, that certain personal luxuries should not be encouraged because it was against the well-being of the nation. Adam Smith expanded on previous political and economic philosophers by allowing self-interest to have a place in serving the greater good of the nation and establishing a societal balance which promoted relative harmony and morality.

This balance derived from self-interest is a product of an innate and universal desire for wealth and the dismantling of rules and regulations that hinder the potential of a free market system. With these two assumptions, competition is allowed to freely provision economic goods to all levels of society. Self-interest will lead to the division of labor. Each person cannot produce what he or she needs individually, and it is in each person’s best interest to truck, barter, and exchange the surplus of one’s products with another. This self-interest leads to unintended social cooperation. Due to the liberated market, the effectual demand of each good will ration the quantity of production of commodities. A relatively harmonious system is created in which people’s needs are met via the market mechanism. What Smith terms the “market” price of a good, its exchangeable value, will tend to converge with the “natural” price, its value in labor, in the long run as well. This occurs because if there is freedom to produce and to consume, it will be impossible to sell a good above its natural price for any amount of time, as there will always exist another producer offering a lower price, pushing the high seller out of the market. Both the natural and the market prices are constantly changing; the market price fluctuating greatly and the natural price theoretically decreasing in the long run because of increased productivity due to the expansion of the division of labor.

Wages and profits will tend to converge towards equilibrium levels in the long run. In the short run, Smith admits they may be “suspended a good deal” from natural levels, but this is only temporary. Therefore, individuals will not, in the long run, be working for more or less compensation than their counterparts in the same occupation. Smith argues this in Book I, Chapter 7 by stating that if in any area, there is an occupation that seems to be very attractive due to its high wages or profits, more people will crowd into it and will eventually balance the wages so that they are comparable to the levels of other similar occupations.

The market’s ability to ration economic goods and equalize occupations is under the assumption that actions do not violate natural laws of justice. These laws of justice are enforced by the government, whose only roles are to provide defense, public works, and a system of law and order. The government should not interfere with the market, not because politicians are inherently evil, but because they could not possibly do as much good as the market is capable of achieving. In this way, Smith’s economic welfare is contained by the government but also allowed to flourish within the dictates of justice. This maintains reasonable, but not perfect, order within the society. The society is constantly moving towards equilibrium, and may obtain it only briefly, but Smith was not describing a static system in which there will be a Utopian state through the division of labor and the free market mechanism. He was, however, describing a system of constant change under which relative order and justice exist.

Once this stability is achieved and maintained, the society may develop its division of labor into other sectors and continue to grow its wealth. The society moves from a primitive sort of society, where agriculture is the focus, to a manufacturing society, which will in turn eventually lead to commerce between other nations. This is also one of the functions of the market. With a liberated market, capital will flow into the appropriate areas—those with the most profit potential. Agriculture is the most “safe” investment, next being manufacturing, and so on: “…as the capital of the landlord or farmer is more secure than that of the manufacturer, so the capital of the manufacturer being at all times more within his view and command, is more secure than that of the foreign merchant” (Smith). In this way, the market may control the appropriate flows of capital due to expected returns and expected risk. As the society moves away from a primitive society, the extent of which the nation may specialize and divide labor increases. The most ideal society that Smith describes uses a sophisticated division of labor, in which there is professional differentiation of labor, and is the most effective. Therefore, productivity is increased and profits will be expected to increase. The growth of the nation cannot exceed the market capacity, keeping it within reasonable levels. Smith defines wealth as the amount of necessities and luxuries an individual has. The increased productivity will therefore lead to higher output and more “stuff” for each person. The market sparks growth that propels the economy forward towards, though never reaching, an optimum level of production and consumption.

As the society reaches a level where it can utilize the division of labor on an international level, the nations involved move continually towards an international equilibrium. Prices and wages begin to balance on a larger scale in the long run, and economic goods are provisioned to all levels of society for all countries involved in the trade. Just as the division of labor was beneficial to nations internally, it is also useful on a global scale. The benefits of trade are evident in Book II, Chapter IV in Wealth of Nations, as Smith notes the costs of production can be decreased by purchasing cheaper goods in foreign countries. The country’s total income is increased by allowing international commerce. Restricting trade only negatively affects the potential harmony that could be achieved through a liberated market by creating monopolies and unjust provisioning of economic goods.

Wealth is also created by the accumulation of capital from year to year. The productive class—mostly manufacturers, will produce more than what is necessary for the subsistence of both the productive and unproductive classes. What is set aside and saved for the next year may be used to generate more productive labor and to purchase new machinery and tools. This will maximize output and will continue to expand the nation’s productivity. Saving is natural, according to Smith in Book II, Chapter III of Wealth of Nations, because it betters one’s own condition and each person is constantly seeking to maximize their well-being: “the principle which prompts to save, is the desire of bettering our condition, a desire which, though generally calm and dispassionate, comes with us from the womb, and never leaves us till we go to the grave” (Smith). It is not, however, the accumulation of capital which expands wealth, but it is the connection that capital has to the division of labor as a nation is constantly moving towards its optimum productivity.

Adam Smith may have been arguing a direction for European economies of his time, but unintentionally set forth a self-sustaining economic system that could adapt to changes easily, contributing greatly to economic equilibrium analysis. Smith’s system had a tendency to align society’s needs and wants with what was produced, as well as providing relatively just prices, wages, and profits.


Chandra, Ramesh. Adam Smith and Competitive Competition. Online Source. .

Fleischacker, Samuel. On Adam Smith’s Wealth of Nations: A Philosophical Companion. Princeton University Press: Princeton, 2004.

Heilbroner, Robert. The Essential Adam Smith. Norton & Company: New York, 1986.

Myers, ML. Adam Smith’s Concept of Equilibrium. Journal of Economic Issues: September 1976. Volume 3, Issue 3, pp 560.

Schumpeter, Joseph. History of Economic Analysis. Oxford University Press: New York, 1976.

Smith, Adam. An Inquiry Into the Nature and Causes of the Wealth of Nations. Liberty Fund: Indianapolis, 1981.

Vivenza, Gloria. Adam Smith and the Classics. Oxford University Press: New York, 2001.

An empirical study on the Turkish J-Curve and the Marshall-Lerner Condition

The Turkish economy has suffered several shocks to its economy over the past 30 years. These shocks have led policymakers to multiple devaluations of the new Turkish lira as an attempt to bring the country out of its increasing current account deficit. The extent and frequency of these devaluations has not led to a surplus in Balance of Payments as expected. Possible explanations for the cause of a “perverse reaction” to devaluation are an unsatisfied Marshall-Lerner condition and a multiple devaluation shifting the J-curve to the right under the Kulkarni hypothesis.

Using simple Ordinary Least Squares regression methods, I will test the effect that a change in exchange rate has on the trade balance for the Turkey since 1980, during which several international trade reforms were implemented. I predict that I will find that the multiple devaluations of the Turkish Lira have led to an indefinitely negative trade balance, rather than a trade balance surplus as policymakers had desired. This perpetually negative trade balance is also potentially due to the consumers and investors’ expectations of devaluation.

Since 1947, Turkey has experienced a negative current account balance. In the 1950s, like most of the rest of the world, the Turkish Lira was fixed, in this case with the United States Dollar. Gross National Product growth was very unstable during this time period, due to large fluctuations in output. The currency appreciated 13% from the period of1953-1959 but did not help the trade balance, as exports fell from 7.6% of GDP in 1953 to 2.0% of GDP in 1958. The Turkish government faced a debt of approximately 1 billion USD in 1958, and devaluated the currency in August of the same year in an attempt to bring the economy out of a negative trade balance. The devaluation was partnered with more liberalized trade policies, though Turkey was still a much-closed economy.

In the 1960s, the currency was particularly overvalued due to inflationary pressures, but the time period was also associated with a reduction in the current account deficit as exports rose from15% of GDP in 1971 to 30% of GDP in 1972. The deficit reduction may have been a result of extensive import substitution policies, which also included a heavy emphasis on investment in manufactured and capital goods. However, producers still relied on importing raw materials for production. In 1973-1974, Turkey suffered from oil shocks that made oil more expensive to import and therefore increased the trade deficit, followed by a second oil shock in 1979. Also in the 1970s, Turkey’s domestic spending started to increase, leading to further terms of trade deterioration. Turkey’s inflation rate remained high, sometimes past 100%, but never reached hyperinflationary levels.

Turkey failed to negotiate a stabilization agreement with the International Monetary Fund in 1978 and 1979, but in 1980, policymakers turned what had been an import-substitution policy into an export-oriented growth policy. These trade reforms were led primarily by the Deputy Prime Minister Turgut Őzal, also the leader of a military regime that took over Turkey during a short time period of 1980-1983. Őzal’s reforms included export incentives such as tax rebates and favorable credit terms. Some restrictions on imports were lifted to encourage trade as well, such as quotas. The Turkish lira was considered overvalued and a devaluation policy was set in place. The country also moved towards a freer exchange rate system, though it was still relatively controlled by the government. Industrialization accompanied the movement of 1980, though it had been taking place along with the import-substitution policies already in place. Turkey began moving from a primarily agricultural exporter to an industrialized goods exporter. As a result of the 1980 reforms, foreign investors also became more confidence in the Turkish economy, which helped to turn the low foreign direct investment from $100 million USD in 1987 to $800 million in 1992.

When the military regime fell and parliamentary democracy returned in 1983, more currency devaluations were instituted. Even though previous devaluations were not particularly effective, policymakers in this time were much more optimistic about the demand elasticities of imports and exports, and thus determined that devaluation of the domestic currency would create a surplus in the balance of trade for Turkey. In 1987, Turkey experienced a mini-crisis where inflation was accelerating out of control, to the extent that real interest rates on deposits were becoming negative. Therefore, people fled from the devalued Turkish Lira and invested in dollar currencies. As a result of the excessive inflation, the Turkish government tightened monetary policy in February of the next year. The government successfully stabilized the currency but slowed growth in the process. The current account in 1988 and 1989 was in surplus temporarily. The 1990s began with a short period of high inflation and growth, creating an increasing current account deficit. In the early 1990s, fiscal policy in Turkey created higher inflation by increasing government spending, leading to an annual inflation rate of 73% in 1993. This further deteriorated the terms of trade and deteriorated the value of the Turkish lira. In 1991, the real GDP per capita was decreasing by 1% annually, along with rising inflation. The Turkish economy faced a mini-crisis in 1994 and the Turkish lira had depreciated by 76% against the US dollar (World Bank and OECD). From 1999-2001, the Turkish government worked with the International Monetary Fund to stabilize the economy by reducing inflation and restoring external balance. Unfortunately, this plan failed in2001 as it resulted in sharp devaluations of the lira, and did not help to control inflation or the trade balance.

Today, Turkey depends heavily on imported oils and fuel, accounting for 20.5% of total imports in 2006.Significant oil shocks during the past decades have helped to further push Turkey into a current account deficit, as oil became more costly. Turkey is also a large importer of mechanical machinery, road vehicles, iron, and steel. Turkey’s major exports include clothing and textiles—accounting for 21.3% of total exports in 2006, whereas road vehicles, iron, steel and electronic machinery are also major exports. Turkey’s main trading partner is the EU, which accounts for 51% of her exports and 45% of her imports, mostly from Germany. Other trading partners include the United States, Middle Eastern countries, and South Asian nations.

The “Marshall-Lerner condition” was theorized in the early 1990s by Alfred Marshall and Abba Lerner to explain why currency devaluations may not lead to a favorable effect on the trade balance of a country. In simple economic theory, currency depreciation will make a domestic country’s goods cheaper to foreign countries, and thus increase exports and create a surplus on the domestic country’s current account. Under a free market system with floating exchange rates, an overvalued or undervalued currency will self-adjust itself via the market mechanism. However, the Marshall-Lerner condition proves that this will only occur if the sum of the demand elasticities of imports and exports are greater than one, and generally holds true for small open economies. This is because in order to have a favorable trade balance after devaluation, import and export demand must be able to effectively respond to the change in exchange rate.

Mohsen Bahmani-Oskooee in his 1998 studies on the Marshall-Lerner condition and J-curve hypothesis found that the Marshall-Lerner condition holds true in most of the 30 developed and developing countries that were tested (Bahmani-Oskooee 101-109). However, Bahmani-Oskooeealso found that in the case of India—always the exception—her elasticities of demand for imports and exports satisfied the Marshall-Lerner condition but the trade balance has deteriorated in the short and long term. Other studies have conclusively proven that the M-L condition continues to be important in determining if devaluation will have a positive effect on balance of trade, if no other factors counteract the positive effects of devaluation. One of these offsetting effects could be if there is a relative increase in income domestically compared to the income of the rest of the world, which would create a higher demand for imports and offset the devaluation effects on balance of trade.

The J-Curve hypothesis states that initially, devaluation will lead to a deterioration of trade balance because the quantity of imports will remain the same for a period of time, and will cost more to domestic consumers. There will have been existing contracts before the devaluation that must be carried through even with the devaluation. Imports will be more valuable as exports remain of approximately the same value. Goods prices do not adjust overnight, and during the period of time that prices are adjusting, there will be a negative trade balance. After producers and consumers adjust their demand to the new currency rates, exports will be more desirable to foreign nations and the trade deficit will turn into a surplus in the long–run. This is under the assumption that the Marshall-Lerner condition holds true. Junz and Rhomberg in their 1973 research study concluded that in order for trade balance to become positive, the lags in recognition, decision, delivery, and placement must be considered.

Studies have found mixed results testing the validity of the J-Curve hypothesis. In Andrew K. Rose’s study in 1990, there was found to be no association between exchange rate and trade balance for developing countries. Rose’s study was somewhat unique because most J-Curve empirical studies only focus on industrialized countries. Empirical evidence has show that the J-Curve hypothesis may hold true for countries such as Egypt, Indonesia, Greece, Korea, Japan, and Spain—that is, after a devaluation of domestic currency, each country experienced a short-term negative trade balance followed by a long-term positive trade balance (Kulkarni 52-63). Some studies that employ disaggregate data have found that the J-Curve may not be apparent if the positive effects of devaluation in one country is offset by negative effects to its trading partners (Halicioglu 3).

Similarly, expectations of devaluation have a considerable effect on whether there will be a positive reaction in exports and imports. If devaluation is unexpected, devaluation is seen to be highly effective, while the opposite is true as well. Sellers will look to make contracts in currencies that are expected to appreciate, so that they will gain more from a transaction, though buyers will want to engage in economic contracts under which the currency is expected to deteriorate, as their costs will be minimized. The theory of rational expectations, therefore, contributes to the hypothesis that multiple devaluations will lead to an increasingly negative trade balance.

Professor Kishore G. Kulkarni tested the hypothesis that multiple devaluations will lead to a perpetual trade deficit for Ghana and found that subsequent devaluations of the Ghanaian Cedi led to a long period of deterioration of terms of trade in the period of1983-1989. In countries that experience only a single devaluation, the effects are more align with the traditional J-Curve hypothesis (Kulkarni 41-51).

There is limited research on the impact of devaluations on Turkey’s trade balance. The research that has been conducted either used bilateral or aggregate data, sometimes with conflicting results. The benefit of bilateral data is that it can show how one country’s trade balance affects another’s. Bilateral trade studies on the J-Curve also more often find positive effects of devaluation in the long-run. A 1997 study found that in the 1970s, there was no relationship between trade balance and exchange rates in Turkey and in the 1980s there existed a negative relationship (Brada et al.). Another study in 2001 discovered a lag of one year after devaluation for trade balance to begin to have a positive behavior, looking at long-run aggregate data (Kale). Independent studies by Bahmani-Oskooee and Rose found no relationship in Turkey between exchange rates and terms of trade. A1991 study on devaluations concluded that a higher exchange rate may be contractionary if it is anticipated (Agenor), while unanticipated devaluations have a greater chance of producing a positive effect on output and economic activity.

For testing the hypothesis of multiple devaluations leading to a perpetual trade deficit in Turkey, I have found trade statistics from Turkey’s 12 major trading partners—Austria, Belgium, Canada, Denmark, France, Germany, Holland, Italy, Japan, Switzerland, the United Kingdom, and the United States. These were Turkey’s most significant trading partners in 2005 according to International Monetary Fund statistics. I have used data from the IMF’s International Financial Statistics database, from World Bank statistics, and from the Organisation for Economic Co-operation and Development Surveys of Turkey. Due to the multiple devaluations chasing rising inflation in Turkey particularly from 1980 onwards, I will attempt to find a relationship between trade balance and exchange rates between the time period of 1980 and 2006.

If we assume that trade balance is a function of the domestic country’s GDP, the trading partner’s GDP, and the real exchange rate, we can assume a linear-logged model for the relationship. The variables are logged in order to make them unit-free. The Ordinary Least Squares static regression model that I will use to fit the data is as follows:

Log(TB)=a₀+β₁log(Y)+β₂log(avgY*)+β₃log((avgP*/P) (ER))+e

Where TB is the annual nominal difference between exports and imports in Turkey, a₀ is the autonomous annual change in trade balance, Y is Turkey’s annual nominal GDP, Y* is the averaged annual and nominal GDP for Turkey’s 12 major trading partners, P* is the averaged Consumer Price Index for Turkey’s trading partners, P is the domestic Consumer Price Index, and ER is the exchange rate expressed in terms of the Turkish Lira’s purchasing power when compared to the IMF’s Special Drawing Rights unit. The SDR is a weighted unit term in the IMF’s IFS to determine exchange rates—it is derived from a basket of currencies as an international reserves unit. The value e is a random error term. I have logged the variables to attempt to keep elasticities relatively constant and to control the large units of these variables.
The estimated value of the coefficient β₁ is expected to be negative, as Turkey’s imports are expected to increase with a rise in domestic income via the import function M=a₀+b₁Y, and therefore will result in a negative trade balance. The estimated value of the coefficient β₂ is expected to be positive, as a rise in foreign income will result in a positive trade balance due to increased exports. However, the estimates for β₁ and β₂may be negative if import-substitution goods are the cause of an increase GDP. The coefficient β₃ is of particular interest to this test because it will assist in determining whether exchange rate, adjusted for price levels, has a positive or negative effect on trade balance. If the partial derivative ∂/∂ER[TB] is negative in the short run, and positive in the long run, the J-Curve hypothesis holds true. If the estimated β₃ is negative in the long-run, the Kulkarni hypothesis that a series of devaluations leads to an indefinitely negative trade balance may be an accurate explanation. I expect the multiple devaluations of the Turkish Lira will cause the trade balance to be indefinitely negative.
I will also test to see if foreign direct investment is affected by Turkey’s currency deterioration. I am expecting that investment in Turkey will decrease with currency devaluation, particularly because of the instability of the Turkish economy and the expectations of further devaluations. I will hold interest rate constant during the test because I would like to isolate the changes in GDP and exchange rate to respective changes in exports and imports.

Finally, I will test the Marshall-Lerner condition and find a value for elasticities of demand for exports and imports in Turkey during the time period of 1980-2006. I will do this by testing the import elasticity function M=a₀+β₁((P*/P)ER) where a₀ is the level of autonomous imports, P* is the foreign country’s price level, P is the domestic country’s price level, β₁ is the amount that imports are expected to change with respect to a one unit change in adjusted exchange rate, Y is the domestic income, and β₂ is the amount that imports are expected to change with respect to Y.

β₁ is expected to be negative because as exchange rate increases (exchange rate here is expressed as domestic currency units/foreign currency units), the domestic currency loses value and thus imports will be expected to decline, as they are more expensive for domestic consumers. β₂is expected to be a positive value, because as the domestic country’s income increases, they will be able to purchase more imports. Similarly, I will test an export elasticity function where X=a₀+β₁((P*/p)ER)+β₂Y*, the only difference in independent variables being the foreign country’s GDP as the value of Y*. The coefficient β₁is expected to be positive as prices become more appealing to foreign consumers. The coefficient β₂ is expected to be positive as well, because as foreign country’s income increases, their demand of the domestic country’s goods will increase as well, leading to a greater value for exports.

The statistical analysis package that was used for this test was SAS, Version 9.1. Data used, program details and output are attached to the end of this paper. I am using aggregate data rather than bilateral trade between Turkey and her trading partners.

The results from testing the a regression expressing trade balance in terms of foreign and domestic income and exchange rates, produced the following results:

[6.22824][.09131][.73519][.44] [s.e]

The estimated β value shows that as Turkey’s GDP increases, the estimated, averaged value of trade balance decreases. This was expected, as Turkey’s income decreases, that there should be a positively increasing demand for imports and therefore a deterioration of the terms of trade. The positive estimated value of β₂ is negative, which was unexpected. This means that as a foreign country’s GDP increases, the trade balance deteriorates even further. This may be due to import-substitution goods in other countries or the sensitivity of unit measurements in the data. The estimated value for the coefficient β₃ is positive, which means that in the long-run, devaluation of the Turkish Lira has a positive effect on trade balance according to the statistics that I have obtained.

To test the accuracy of these regressions, I conducted a 95% confidence interval for the estimated value of β₃. I found that the estimated value of β₃ for the Trade Balance equation was between .77986 and 2.58562. This allows me to state with 95% certainty that the true value for β₃ is positive, and therefore exchange rate deterioration has a positive effect on trade balance in the long-run. The adjusted R-squared value obtained from this regression was .7883, out of 1, and helps to explain how well the data fits the regression model.

When I isolated the years 1980-1990 and performed the same test, I derived the following regression:

Log(TB)=-35.82520 -.28647Y-.11370Y*+2.30724((P*/P)Log(ER))+e
[15.47301][.54657][.2.57417][.94041] [s.e.]

The negative value of b₁ shows that as domestic GDP increases, the trade balance deteriorates, which is in line with traditional international economic theory, as imports are expected to increase as domestic income rises. The value of b₂ is negative, which was unexpected, because as foreign income increases, they will demand more of Turkey’s products and exports should increase. The positive value of b₃ is of particular interest because it is of positive value and a greater value than the b₃for the long-term regression. Running a confidence interval for the value of b₃ in this short-term regression, I can say with 95% certainty that the true value of β₃ lies between .377518686 and .4.23696132. Therefore, it can be concluded that the derivative of a change in exchange rate with respect to trade balance is positive in the short-term. That the value of b₃ is greater than in the previous regression assumes that the trade balance was even more responsive to devaluation in the 1980s than over the long-term. Therefore, the devaluations and policy reforms of 1980 were relatively effective in turning the negative trade balance around. However, this does not support the theory of a J-curve, as the partial derivative ∂/∂ER[TB] is positive in the short and long terms.

The analysis of 1990-2006 shows similar results to the long-term regression model, but with a positive value for Y*, more aligned to traditional economic theory that exports should increase as foreign GDP also increases. The value for ∂/∂ER[TB] is again positive at 1.88340.

When testing the foreign direct investment changes with respect to exchange rate, the data obtained is estimated in the following regression:

Log(FDI)=65.83022-4.16918((P*/P) (ER))+e
[40.39278][2.92040] [s.e.]

The negative coefficient of b₁tells us that as exchange rate deteriorates, the foreign direct investment will also decrease. As the domestic currency is devaluated and is cheaper in real terms, there will be less investment and less confidence in the currency, thus making direct investments deteriorate as well. It seems reasonable that the number of devaluations of the Turkish Lira have created negative expectations for the rational investor, and even if exchange rates were to appreciate, investment would most likely be slow to recover because of the history and expectations of devaluation. The overall values of foreign direct investment have increased steadily for the years 1980 to 2006 (see Figure 2), showing an increasing confidence in the Turkish economy, despite the series of devaluations of the Turkish lira.

From testing the Marshall-Lerner condition, the import elasticity function that was used for the test gave the following result:


This function shows that as the price level changes by one unit value, the volume of imports are expected to decrease by .06581. When fitting the data to the export elasticity of demand function, I found the following equation:


This function tells us that the coefficient for the percent change in price with respect to the quantity exports is .04226. When this is added to the coefficient for the percent change in price with respect to the quantity of imports, the absolute values for the elasticities add up to .10807. Since this value is not greater than 1, the Marshall-Lerner condition is unsatisfied and according to theory, the devaluation of currency will not lead to a long-term trade surplus. Although short-term elasticities were not analyzed, it should be assumed that the long-run elasticities of demand for imports and exports are more accurate than short-term, as elasticity is dependent upon time and the availability of substitute goods. However, this is not to say that the elasticity of demand for imports and exports were not larger during the time of devaluations, such as the sharp devaluations of 1980, 1994, and 2001.

Through this primitive study, it may be assumed that the trade deficit for Turkey has been narrowing throughout the past 27 years. Devaluation of the Turkish lira has been shown to have a positive relationship between trade balance, even though the Marshall-Lerner condition was not satisfied. If the Marshall-Lerner condition was in fact satisfied, perhaps Turkey might have been able to free itself from a perpetually negative trade deficit. It may also be concluded that investors are less likely to be interested in the Turkish economy if it is devaluating its currency. Expectations of devaluation are also likely to decrease the confidence in the Turkish lira and in investment in the country—as shown by the larger value of ∂/∂ER[TB] when devaluations were effective in 1980, rather than a smaller value of ∂/∂ER[TB] when the devaluations could have been expected and therefore had a lesser positive effect on trade balance. However, because of the results of the f-test performed on the regression, there may be other facts affecting trade balance that should be considered.

The Kulkarni hypothesis holds loosely for these results. The trade balance was perpetually negative, perhaps due to the subsequent devaluations of the lira as Kulkarni suggests, but devaluations had a positive effect on trade balance in the long-run.

Units Measurements Used:
GDP For all countries= Billions/National Currency
CPI=Unit Measure
ER=Purchasing power of Turkish Liras/SDR (market rate, end of period)
Exports and Imports=Millions/USD

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