Professor Paul Palley's
          Economics Seminars

A good editorial (http://www.nytimes.com/2010/03/07/opinion/07sun1.html?ref=opinion) explaining why passing health care reform is important.

Here is an interesting column (http://www.nytimes.com/2010/03/07/opinion/07friedman.html?ref=opinion) about the benefits of investing even during bad times, and how people are working on clean energy sources at the same time.

Energy and especially oil prices are important variables to consider when evaluating both current and expected economic trends. Higher energy prices lead to higher costs for business and government operations, and higher costs associated with transportation, infrastructure development, and utilities. Virtually all economic activity is dependent on energy consumption to some degree. This means that evaluating trends and assessing energy price forecasts should be a critical part of decision-making. What the data shows is that during the period of 1986 to 2002 oil prices remained very low and in a narrow trading range except for a brief period in 1990 when oil price rose due to events around the Gulf War. Then during the period of 2003 to 2006 there was a period of steady increases in oil prices mostly due to global economic growth and economic development (especially in Asia). What occurred then in the 2007 to 2008 period was a sharp increase in oil prices. This spike in oil prices has increasingly been seen by analysts as a period of exceptionally strong speculative demand for oil rather than an increase supported by economic fundamentals. This indicates that speculation is an important factor in affecting oil prices as investors are free to choose from a range of investment opportunities including stocks, bonds, currencies, and commodities including oil. This spike in oil prices did not necessarily trigger the severe financial crisis and recession that started in December 2007, but it did not help either

There are many very good resources to go to follow trends, news, and issues related to energy. Among these include the Department of Energy, Energy Information Administration (EIA) which provides an excellent resource for those interested in energy related issues and topics, details about energy sources, state and U.S. historical data, and energy and oil prices data and forecasts. The link for this resource is: http://www.eia.doe.gov/. The current price of oil is approximately $75 per barrel. The Department of Energy, Energy Information Administration (EIA) projects steady increases in oil prices to sustained prices over $100 per barrel by the end of this decade (sustained is the key word here). This is logical as economic growth will increasing solidify the further we get from the recession of 2007-2009. The International Energy Agency (http://www.iea.org/) is also a very good resource for those interested in issues related to energy, and also related data and statistics as well as information related to energy technologies. In addition, the U.S. Bureau of Labor Statistics (http://stats.bls.gov/) is one of many valuable government resources. It can be an especially useful resource for both consumer and producer price indices, including those related to energy, infrastructure, and utility prices.

There are many other very good resources online that can be freely accessed for energy related news and information. The following is just a short list. The Wall Street Journal (http://online.wsj.com/home-page) is a good resource for daily business, world, and national news, including details about energy related topics and market data. Included in this coverage is news and reports focused on the commodities markets (http://online.wsj.com/public/page/news-oil-gold-commodities.html). There are Blogs that are also available to be read that periodically focus on energy related news and issues, topics, markets, and prices and are considered to be reliable resources for daily reading. Some of these include MarketBeat (http://blogs.wsj.com/marketbeat/), and Real Time Economics (http://blogs.wsj.com/economics/). The New York Times (http://www.nytimes.com/) is another good daily resource for business, national, and world news, including details related to energy related topics and market data. Separate science and technology sections are included in the online edition that periodically focus on energy related stories. The business section (http://www.nytimes.com/pages/business/index.html) includes a focuses on global markets, markets, and economy. The market related data and quotes include oil and other commodity prices. More specific to the topic is a separate section (http://www.nytimes.com/pages/business/energy-environment/index.html) whose focus is the energy and environment.

Daily details and news updates about energy, technology, and commodities and energy prices are available on other websites. These includes CNNMoney.com (http://money.cnn.com/), MarketWatch (http://www.marketwatch.com/), Yahoo!Finance (http://finance.yahoo.com/), and Bloomberg.com (http://www.bloomberg.com/?b=0&Intro=intro3) among others. The price quotes seen on these websites are the result of trading activity in the commodities markets. Information related to this is available through the CME Group (http://www.cmegroup.com/) which is a CME/Chicago Board of Trade/NYMEX Company.

Efforts to maximize profits over time focus on increasing revenues and reducing the cost of doing business. The ability of a firm to increase revenues will depend either on the ability of the firm to increase the demand for their product (outward shift of the demand curve), or to realize greater revenues due to a change in the price of the product (this depends on the price elasticity of demand). Invariably, the market structure within which the firm competes will also greatly impact the ability of a firm to enhance its profits. On the other hand, efforts to reduce the average costs associated with producing a product depends on the ability of a firm to more effectively utilize its resources or to employ new technology to increase productivity.

All firms maximize their profits when they produce a level of output where the marginal revenue equals the marginal cost. The logic is as follows; as long as the marginal revenue exceeds the marginal cost then the additional revenue that results from producing the next unit of output will exceed the cost associated with producing the next unit of output. As a result, the firm will see its profits increase and it should produce more. It will then produce more, and continue to do so until the marginal revenue equals the marginal cost because every unit of output produced up to this point will lead to greater profits. With this definition established, the next step is to focus on each market structure.

In the case of firms that compete in the pure or perfect competition market structure, the problem of profit maximization is a very difficult one to solve. They are contrained to charging the market price and they participate in a market structure where firms are free to enter at will. Any profits lead to new entants and those profits will then disappear. As a result, these firms will focus primarily on cost control. They look to become more productive as a way to lower their average and marginal costs. The classic example of these firms would be that of farmers. Farmers are largely tied to market prices as they are determined in the commodity markets. You will therefore see them focus on cost management.

Monopolists face the market demand curve because they are the only firm providing the good or service in that market. As a result, on the revenue side of the equation they can focus on the price they charge and also seek to increase demand for their product (outward shift of the demand curve). Adjusting the price they charge will either lead to an increase or decrease in revenues depending on the price elasticity of demand. If demand is price elastic then higher prices will lead to lower revenues but lower prices will lead to an increase in revenues. If demand is price inelastic then higher prices will lead to higher revenues but lower prices will lead to an a reduction in revenues. Many monopolists face a demand curve that is price inelastic (local utilities are a classic example). The other opportunity to increase revenues will be through marketing efforts, the introduction of new products, or by exploiting changes in economic conditions, to enjoy an increase in demand. Then at any given price people will want to buy more of thei firm’s products. Remember also that any change in output will lead to a change in the cost of production. The firm must keep this in mind. If the firm is operating at a point of diminishing returns then the firm’s marginal and average costs will increase as ouput increases. The firm will seek to mitigate this by working to employ new technologies or other means to increase productivity and lower the firm’s marginal and average costs.

Firms who compete in the monopolistic competition market structure face the same opportunities that monopolists do in that they can attack both the revenue and cost sides of the profit equation, but with a very important difference. They have to contend with many more competitors producing similar substitutes leading to a demand curve that is far more price elastic. As a result, higher prices will lead to lower revenues but lower prices will lead to an increase in revenues. The problem with lowering their prices is that competitors can follow suit leading to price wars. The lower prices may also hurt their image in the marketplace. Instead, monoplistic competitors will seek to differentiate themselves from their competitors in order to retain control over the price they charge (restaurants are good examples of this). The cost side is also important because they do face a significant amount of competition and as a result they face a lot of price pressures. They will therefore work to increase productivity to manage their costs. The oligopolist faces the same issues monopolistic competitors face, but the number of competitors is greatly reduced. As a result demand tends to be more price inelastic. The competition among a small group of strong competitors can be very fierce making product differentiation very important.

Think about the firm you work for. How do they maximize profits and what competitive conditions do they face that affect their profit outcomes?

Here are two links that argue that marginally higher inflation rates would be beneficial in two ways. The first is that it would justify higher wages, and second that because it would result in higher nominal interest rates. These higher nominal interest rates would allow for more flexibility by the Federal Reserve and other central banks to lower interest rates when necessary to fight recessions. This is a controversial proposal because over the course of the last three decades low inflation targets have been set by central banks, emphasizing the importance of low rates of inflation. As a result a change in policy would be required. Then again, very low inflation and interest rates are identified as factors contributing to the financial crisis that deepened dramatically in 2008. At the same time policy makers would need to make sure that inflation does not get to be too high due to the change in policy. Here are the links to the first article (http://www.imf.org/external/pubs/ft/survey/so/2010/INT021210A.htm) and the second article (http://elsa.berkeley.edu/~akerlof/docs/inflatn-employm.pdf).

What do you think?

Here is an interesting column written by former Chairman of the Board of Governors of the Federal Reserve, Paul Volcker, about how to reform our financial system: http://www.nytimes.com/2010/01/31/opinion/31volcker.html?ref=opinion

See this link for an interesting and provocative comparison of the relative economic strength of the U.S. versus Europe: http://www.nytimes.com/2010/01/11/opinion/11krugman.html?ref=opinion

It is understandable that many are looking at the years of 2000-2009 as being a particularly bad period for the American economy. Job creation was virtually nonexistent overall and many millions lost their job during the recession of 2007-2009. Compared to the strong job creation years of the 1990s, the recent decade looks even worse. Incomes stagnated for all but those in the upper 5%. Economic growth measured by real GDP was notably poor compared to other decades. What we see are patterns of explanation for this that emerge by looking at the data, but we also see what has been a relatively poor performance by the economy over the course of the last thirty years compared to the prior thirty years. What we also see is that underlying weaknesses in the economy have emerged over the course of this period that has increasingly taken hold, and only periodic bubbles in selected markets masked these trends. The technology and stock market bubble in the late 1990s at least did leave behind important new companies, communications infrastructure, and technology. The housing market bubble left in its wake little that can be considered to be positive. At the same time we have seen incomes stagnate and American workers feeling less confident in a globalized world that increasingly results in more competitive capital and labor markets.

Real Gross Domestic Product (GDP)

The data (the source is the Federal Reserve Bank of St. Louis) demonstrates the fact that the economy has generally performed worse since 1980 than it did during the prior thirty years. Real GDP grew at an average annual rate equal to 3.96% during the period of 1950-1979 versus an estimated 2.71% during the period of 1980-2009. This relatively weak result since 1980 occurred during a period when lower taxes and deregulation were argued to be the primary drivers of economic growth. It has at the same time been increasingly noted in the press that the percentage of GDP dedicated to forms of public investment was also much lower and educational attainment suffered greatly compared to other industrialized countries. This is true even as workers in the U.S. are facing an increasingly competitive world. For example, expenditures as a percentage of GDP on public infrastructure exceeded 3% from 1950 to 1970, but since 1980 it has been less than 2%. It is a fact that bottlenecks due to infrastructure limitations, whether they be at airports, on freeways, or at the ports, all decrease productivity. While this decline in public investment in the U.S. occurred, economies in Asia are rapidly modernizing.

Looking at data on a decade by decade basis further highlights the weaker results. The economy grew at an average annual rate of 4.17% during the 1950s, 4.44% in the 1960s, 3.26% during the 1970s, and then 3.05% in the 1980s, 3.19% in the 1990s, and in period of 2000-2009 the average rate of growth was an estimated 1.89%. This outcome for the last decade is very anemic. The period of the 1980s was also especially disappointing given the policy changes enacted. If we excluded the recession year of 1980 then the average rate of growth would be 3.42% for the period of 1981-1989. However, I have to note that as we would expect from a long period of very poor results from 1980-1982, the economy bounced back strongly in 1983 and 1984. This outcome would probably be anticipated regardless of fiscal policies. On balance then, the 1980s was also a disappointing decade.

Real Household Income

The graph above demonstrating trends in real household income (the source is U.S. Census Bureau) illustrates what many people clearly realize. We see that all groups to different degrees lost ground during the period of 2000-2008 (the results will be worse if data for 2009 was included), but we can also see that the distribution of income has changed significantly. Household incomes in the lowest 40% have not seen real gains in income over the course of the last forty years. Those in the third and fourth income groups, those at between the 40^th and 80^th percentiles (middle to upper middle class) saw their household incomes increase in the late 1980s and late 1990s, but as we can see the gains were marginal at best. What is clear is that the vast majority of the gains in household income since the middle of the 1980s were primarily confined to those in the top 5%. This significantly widened the distribution of income to levels not seen since the late 1920s before the Great Depression. In 1980 the top 5% earned approximately four time what those in the middle quintile earned, but by 2008 the ratio was nearly six to one. Over time, as the middle class saw its income growth stagnate, saving rates declined to nearly zero before the recession of 2007-2009 started, household debt increased significantly, and the stress associated with paying for necessities increased. As the stock market has performed exceptionally poorly during the later years analyzed here and the housing bubble burst (see below) wealth accumulated by the middle class has declined to exceptionally low levels given the future needs of this population as they approach retirement, and stagnate incomes indicate difficulty for future wealth accumulation.

The Stock Market

The real or inflation adjusted performance of the stock market as measured by the Standard and Poor’s 500 Index (the source is Yahoo! Finance) reflects important trends because the stock market indicates both the current and expected economic environment. The graph above demonstrates that while there were up and down years during the period of the 1950s and 1960s, the general direction was for real gains in the stock market, consistent with the relatively strong economic growth during this period. The 1970s were a period in which exceptionally high rates of inflation negatively impacted the stock market due to poor fiscal and monetary policies at the end of the 1960s and in the early years of the 1970s, and the oil crises that occurred. In fact the 1970s was a chaotic period economically, but the economy grew at a rate that was approximately equal to that of the 1980s and 1990s. What we see above then in the 1970s was the result of the impact of high rates of inflation and related uncertainty in the financial markets. Then starting in the early 1980s was a stronger stock market, but overall, adjusted for inflation, the market did not match its level of 1968 until 1991. What we also see after this was steady improvement until 1994, and then the stock market bubble occurred, and then a collapse. Another bubble associated with economic growth and financial speculation related to the housing market bubble led to another surge in stock market values until the financial crises of 2008. Indeed, the period of the 2000s was overall negative for investors. Given the details above related to the economy, it is not surprising that the stock has performed poorly in recent decades.

Contributing to the results described above was also efforts to deregulate the financial markets in the 1980s and 1990s, and then a series of subsequent financial crises since the late 1980s. The result is what has been called the “bubble” economies of the 1990s and 2000s. Overall, during the period of 1950-1979 the S&P 500 adjusted for inflation increased at an average rate equal to 3.92%. On the other hand, during the period of 1980 to 2009 the average real rate of return was 5.86%, but if you exclude the speculative bubble years of 1994-1999 when the return was 23.41%, then the return was only 2.35%. In other words, only the speculative stock market bubble years were a real net gain in those years versus the prior decades. As indicated above, the difference between the 1990s and 2000s is that the 1990s gave us significant investments in communications infrastructure and technology along with a series of important cutting edge companies, but the housing market bubble seems to have yielded little of value.

Home Prices

The Standard and Poor’s Case/Shiller price index clearly indicates trends that will not surprise anyone who owned, bought, or sold a home during the 2000s. Historically home prices have increased at a rate roughly equal to the inflation rate. As a result households tended to view the equity they owned in a home as a stable asset or source of wealth accumulation. Both low interest rates and free lending practices that were either supportable or not facilitated efforts to finance home purchases in the 2000s. The poor stock market (see the relevant section above) caused households and investors to seek alternate investment opportunities, and this also led to increases in investment in housing. Over time the speculative demand for housing increased beyond levels supported by economic fundamentals. Other factors were also at work, but poor regulatory practices, very loose monetary policies, and very poor corporate governance, and greed were the primary factors that led to the speculative bubble depicted above both nationally and in a bubble city like the Phoenix-area. If you bought a home in Phoenix prior to 2001 than you are now marginally ahead, but if you bought after this time than you are likely not. Those who own a home in some separate local markets in the Phoenix area faired better. The results nationally during this time horizon have faired better with the value of their homes. On the other hand, the diversion of funds from alternative investment opportunities to housing and related financial assets, and the subsequent financial crisis starting in 2008, has a terribly negative impact on the economy. In addition, seeing as massive of a decline in asset values as depicted above leads to long-term reductions in expectations and greatly weakens household consumption.

Interest Rates

Exiting the high inflation and interest rate environment of the 1970s and early 1980s, the data (the source is the Federal Reserve Bank of St. Louis) for key interest rates demonstrate a process of lower and lower rates. Low interest rates were the natural result of the lower inflation expectations that took hold due to effective monetary policies in the late 1970s to the late 1980s, the impact of globalization, and other structural adjustments in the economy. We see this in the pattern shown above for long-term interest rates like the 10-Year Treasury and Mortgage rates. On the other hand, there were two occasions when it can be argued that Federal Reserve policies were too loose. These periods followed the recessions of 1991 and 2001. This is illustrated in the top graph above in this section by the long period of time in which the Federal Funds rate was kept at relatively low levels. This policy decision was prompted by the slow recovery of the labor markets after the recession, but as we have seen above we were really in a long period of relatively weaker economic performance. Added to these low interest rates, and arguably much more important, was a very weak regulatory posture due to policies by politicians and the Federal Reserve. Cheap money combined with a weak regulatory stance does contribute to speculative bubbles like those described above. It is also not surprising that the combination of easy credit, low interest rates, and households constrained by meager income gains seeking to leverage what they do have will lead to an explosion of household debt.

Conclusion

The economy has changed greatly in recent decades. Globalization, the pervasive use of technology (especially communication technology), computing, and an increasing level of competition have all altered the economy positively and negatively depending on one’s point of view. On balance, we have seen a rapid advancement in technology that is positive. Increasing productivity and competition were important factors contributing to the lower inflation and interest rate environment. Globalization leads to great connectivity among economies, and in the long-run this should be positive. Yet, in many ways the U.S. economy has underperformed for the vast majority of the population. As I indicated above, economic growth in recent decades has lagged behind trends associated with the thirty years starting in 1950. Incomes have stagnated for most of the population, and income inequality has grown to levels not seen since the 1920s. The stock market and housing market created speculative bubbles facilitated in part by investors divorcing themselves from economic fundamentals and deregulation combined with very poor corporate governance. These problems all call for the identification of solutions. Economists will turn to the efforts that increase productivity and competitiveness when identifying solutions. These include increasing investment in education, research and development, and infrastructure. In addition, in order to facilitate efforts by the public to adapt to the changing economic environment, institutions and programs that promote geographic and employment mobility are important.

The Economic Stimulus Act of 2008 included tax rebates that were supposed to help with the effort to jump start the economy. Debate related to the relative effects of government spending versus tax cuts was reignited in the press as the act was designed and then passed. This report (see link included below) completed by the Federal Reserve indicates that only one-fifth of those surveyed significantly increased their spending due to the rebate. More than one-half of those surveyed used the money to primarily pay off debt. The evidence is that only one-third of the rebate was spent (this is much lower than hoped for). The results further explain why short-term increases in government spending has a much greater positive impact on the economy than tax rebates when the economy is in recession.

The link is: http://www.federalreserve.gov/pubs/feds/2009/200945/200945pap.pdf

Uncertainty related to the current and future strength of the economy following the deepest recession since the Great Depression results in people looking to experts for forecasts. The Great Recession is technically over, but uncertainty prevails. The National Association for Business Economics (NABE) is an excellent source of economic forecasts. The November 2009 NABE Outlook (see: http://www.nabe.com/) indicated an improved outlook for 2010, and that companies should start adding jobs soon. NABE also indicated continued slow growth in household spending, but business investment and corporate profits are more positive indicators. The dollar will weaken marginally, and housing starts will improve significantly but remain well below long-term trends associated with normal economic conditions. The consensus is that inflation rate will remain low due to the relatively weak economy as illustrated by the expectation that the unemployment rate will remain high by historical standards, and the Federal Reserve is not expected to start tightening until next spring. The forecast represents the consensus of macroeconomic forecasts that have been prepared by a panel of 48 professional forecasters.

Real GDP declined at an annual rate of 1.9% during 2008. Then there was a severe decline in real GDP at an annual rate in excess of 5.0% during the first quarter of 2009. This is the worst result for the economy in fifty years. Overall, it is expected that real GDP will decline 0.2% in 2009, and then show improved economic growth equal to 3.2% in 2010. This reflects relatively weak increases consumer spending. As indicated above, improvements in business investment, especially in inventories and to a lesser extent in equipment and software, are expected. The very weak housing market and the significant decline in wealth due to declining home values are the primary reasons for continued weakness in personal consumption expenditures. The consumer price index is expected to decline 0.3% in 2009 due to weakness in the economy and the labor market, but this deflation should not continue into 2010 as it is expected the inflation rate will equal 1.8% in 2010. Improved stability in the credit markets and the very robust rally in the stock market are positive indicators. Significantly below trend levels of housing starts and home prices will occur in 2009. Only 580,000 housing starts are expected in 2009, and only 790,000 are expected for 2010. The majority of analysts believe the housing market has bottomed, but a slow recovery is expected.

The absence of inflationary pressures allows the Federal Reserve to pursue very aggressive monetary policies. The consensus of the economists who were surveyed by NABE is that the Federal Reserve will leave the federal funds rate target this year at nearly 0.0%, but that it will raise it to the still very low rate of 1.00% by the end of 2010. The expectation is also that long-term interest rates will also remain relatively low. The yield on the 10-year Treasury note is expected to equal 3.50% at the end of 2009 and increase to 4.15% by year-end 2010 reflecting the expected improvement in the economy. These relatively low long-term interest rates, party the result of aggressive monetary policies, will contribute to low mortgage rates.

The strength of the dollar is important to those who are interested in traveling and those who import and export goods and services. The dollar strengthened when the financial markets crisis deepened during the second half of 2008 as global economic weakness led investors to purchase dollar denominated assets to try to hedge against risk. One Euro bought 1.58 dollars in July 2008, but bought only 1.32 dollars in January 2009. Since then, improvements in the stability of the global economy led to a resumption of weakness in the dollar. The economists expect the dollar to continue to be relatively weak in 2009 and 2010. One Euro is expected to be able to buy 1.48 dollars in 2009 and 1.47 dollars in 2010. Reflecting the expectation that the economy will start to strengthen later in 2009, the S&P 500 Index is expected to end 2009 at 1095 and end 2010 at 1199.

There are other very good resources on the internet for forecasts related to the economy and specific economic indicators. Among the good resources include websites for the Congressional Budget Office (http://www.cbo.gov/), The Federal Reserve Bank of Philadelphia’s Livingston Survey (http://www.philadelphiafed.org/research-and-data/real-time-center/livingston-survey/), Mortgage Bankers Association (http://www.mbaa.org/), National Association Home Builders (http://www.nahb.org/), and Freddie Mac (http://www.freddiemac.com/).