Previously, we have discussed about how any attempt to raise a nation's wealth by printing money (or in fancy term, Quantitative Easing) would be futile without prior growth in production, both goods and services. The demand-pull inflation, the depreciation of currency value due to the delusion people hold (they feel richer) when having more money printed out of thin air, renders this approach ineffective. Is that all though? Nope. The repercussion does not stop here. I dare say that any reckless decision based on personal whim, rather than on well-studied reasons or systems, can incapacitate the whole economy, or at least, some sectors within it.
First, you must know that though an economy heavily depends on production of goods and services, the role of money as a medium of exchange is indispensable. We work to earn money. We then use it to purchase various goods and services as needed and desired. So what will happen if the $100 bill we hold suddenly depreciates in value? You know it, I know it, She knows it, Everyone knows it. When our money depreciates, we can purchase less goods and services just as mentioned in Part 1 of this article. In other words, inflation erodes our purchasing power. If our wage is not pegged to the CPI (Consumer Price Index, a metric measuring inflation about which I will probably explain more in my later article ), then we are in big trouble. Wage that is adjusted following the change in inflation rate can, to a certain degree, cushion the adverse effect of inflation. However, those living with fixed wage, ex: retirees depending on pension, will surely suffer as the real value of the pension paid to them is becoming lower and lower. This, in a way, is a means of stealing people's money by the central bank or the government. By printing more money, making you feel richer, they are making your hard-earned cash worth less, turning you into a poorer being in real term.
That is not all. When inflation increases, the real interest rate you obtain from whatever amount of the loan you made will fall. Think of it this way. I will make it simple. Imagine you lend me $1000 with 10% interest. So with no inflation at all, the money you would get back is exactly $1100 in real term, a $100 profit. What if there is 50% inflation? Simply put, that means you are still getting $1100, but its real value is 50% less (because price of goods rise by 50%). So the actual amount you get from making this loan is actually ($1000+$100)*0.5 = $550. Well, you are losing $450 of the initial principal, the original sum lent of $1000.
Inflation can also affects people's perception of the economy. When there is high inflation, people tend to save less (because the value of their money, if saved, will just get lower and lower) unless the bank offers high interest rate, at least, as much as the inflation rate. That means if the money is losing 20% of its value annually, the bank must be willing to offer 20% return (interest) of the amount deposited in order to attract customers. Plus, if the interest rate is fixed by the central bank, rising inflation will increase demand for loan accompanying with much lower supply of it. The problem is, just as in the previous example, people know for sure that if they borrow $1000 now and spend it, they can just pay back much less in real term in the future because inflation eats away the value of the $1000 and the interest they are obliged to return. However, people with surplus of money (saving) are not stupid. They know they will get less if they lend their money out to those opportunists. So the most rational decision is to spend the money now, buying as much goods as they can, investing in assets and commodities, which in turn, will worsen the effect of inflation, and shake the very foundation of the market. You might end up seeing precious metals price such as gold price jumping through the roof, but at the same time, there might be much less saving, thus less investment, a vital component of a country's GDP.
While saving (which constitutes the supply of loan for new investments) shrinks, Inflation greatly discourages investors (the demand side of investment) as the expected return from their investment in existing or start-up business becomes less and less. For instance, if the expected return of the investment is 40%, but the current inflation rate is 50%, that means you will lose 10% if you decide to invest. So high inflation rates can significantly lower the propensity to invest within a country.
If we look at the foreign trade sector, we will know for sure that inflation is bad. Inflation will pose 2 major challenges for the global competitiveness of a country. First, inflation increases the price of goods and services within a country, and that means, at the start, domestically produced goods and services cost higher than the imported ones. People, consumers in general, will normally choose lower price products, so local businesses now have a hard time competing with those of the foreign ones who are not suffering from the inflation pressure (to raise price). This holds true to both the local and the global markets. Thus, domestic producers will be susceptible to bankruptcy, threatening higher unemployment rate and many other problems within that particular economy. When the demand for foreign goods increases and the demand for domestic goods decreases, what will happen is the depreciation of the domestic currency (i.e. the domestic money declines in value). Why? Think about the demand and supply. More demand for foreign products is equivalent to more demand in exchanging domestic currency to foreign currency to purchase those foreign goods. You know where this is going, right? More demand for foreign currency and less demand for domestic currency will eventually increase the value of foreign currency and lower the value of domestic currency. As the domestic currency depreciates, foreign investors will face a huge loss. It is almost as if they are getting ripped off. For example, you are a US investor. You invest in the Japanese market, and you earn 1,000,000 yens. At that time, 1 yen = $1 (of course, it is just an example). Since Yen has depreciated, now 1 yen = $0.5 (yes, just an example). So before the inflation took off, you can convert your return of 1,000,000 yens to dollars, and you would get exactly $1,000,000. Not bad. But now, since 1 yen = $0.5, your 1,000,000 JPY is reduced to only $500,000. You know what? You have just lost half of your return. As a result, it will certainly discourage you or any other investors to consider Japan as a potential target. Worst case scenario, Japan will be labelled as a country with high risk lower return for investment.
High inflation effect can be seen everywhere. Just for the fun of it, I will give you another example of how inflation might affect your business. If you own a restaurant, with high inflation, you must change your prices often to keep up with the rising prices in the economy. This is costly because you need to spend your time and energy doing it, and not to forget, you also need to probably print new menus!
Well, inflation seems to hurt, but economics is not a straight-forward social science. Economics confuses a lot of people because they tend to think of it from only a corner of view. Inflation, though seems hazardous, also have its positives. However, when we are talking about inflation, note in mind that there are different levels of inflation. Economists tend to favor a low and steady rate of inflation because they (and I) think that it is good for the health of an economy. In the next article, we will look beyond our pessimism, and explore the positive space of inflation.
Because when a cup is half empty, it is also half full.
Tuesday, February 18, 2014
Friday, January 24, 2014
Why can't a country just print more money to be rich? (PART 1)
Back in the old day, when I was about 8 or 9 years old, I was curious about one thing, among many others, in particular, money. Why do people work so hard for it? Why don't we use leaves as money? Why cannot the government just print more money if it is so valuable and "printable"? After all, this would solve the world economic crisis which happened every now and then. I thought I had made a major breakthrough in modern economic thinking. Well, I was not very thrilled when reality struck. That, to be honest, was the inception of my unwavering love for economics, way before I even realized what it really is.
It turns out money is just a medium of exchange, and that, the whole economy is anchored on products and services it produces. So to explain this economic phenomenon, let's just forget about money. The wealth of a nation is not the amount of money it has, but the amount of total outputs it generates and accumulates. After all, you would not survive with a million bucks if you were in the middle of Sahara desert. True, don't you think? Because the amount of goods and services Sahara desert has to offer is virtually ZERO. Thus, I guess (and I am pretty sure) that you would be willing to pay a truckload of cash (Benjamins), let alone a million dollars, for just a bottle of water. How can it be so expensive? Because it is so scarce, so rare to be found, in Sahara that a bottle of water is worth any amount of money you can possibly imagine. This means that its price is merely a signal of the scarcity and the demand for water. If you think of it this way, I guess it will help you to better grasp the concept of economics, especially money.
If a nation prints 10 millions more of $100 bill, it does not necessarily mean that its people are now any better off than how they used to be. Look at it this way, if a poor country suddenly prints more money, but it still produces the same amount of outputs with no increase in employment or natural resources, that country, technically, is still poor in real economic sense. So what are the outcomes of having more money but same level of goods and services within an economy?
Imagine living in a small village with no apple tree, no apple import (i.e. a closed economy). While walking, you kick a genie, woke him up, and the genie now grants you 1 wish. Where are the other 2 wishes? Well, I wouldn't grant you 3 wishes, let alone 1, if you kicked me. He is just too kind. Anyway, now you ask him to bestow upon you, 2 apples (who needs a billion bucks, or even better a huge mansion with unlimited wealth inside, when you can have free apples?). You now have become the only person in the entire village to own 2 apples. Now everyone, especially the rich, would be willing to pay you high price, say $1000 just for a bite. I meant they have never tasted apple before. Until, someone else kicks the genie again, and ask for a billion apples (That is why maths is important because by studying maths, you can count more than 2). All of a sudden, your 2 apples are now worthless because the village now has tons of apples on its hand that it does not even know what to do with them.
This specific scenario, as described above, should be quite similar in nature, and thus, comparable to reality. Money and apple are two different things, but the law of supply and demand are applicable to both items. When apple supply spikes, its value depreciates/declines. When money supply increases (while the output produced remains unchanged), its value will simply fall. In other words, as people get more money in hands, they feel richer, and as a result, they start to demand and consume (buy) more. The demand for goods and services rise, but since the quantity of output is the same as before (remember, we only print more money, NOT produce more), then high demand will turn into a competition, thus bid up the price of each good and service. Simply put, people, who are now richer as a result of having more money within circulation, are not afraid to spend. They compete to get what they want, and in doing so, they either directly or indirectly raise price in the economy. The golden rule is when something is strongly desired by everyone, its value appreciates/rises.
I will give you another example just for fun. You bake a pie, and you hand out 2 tickets to people, each worth half a pie. Now suppose, instead of handing out 2 tickets, you hand out a thousand tickets. Each ticket is now almost worthless because each can only be exchanged for a really really thin slice of pie (1/1000 pie). This is what printing more money does to you when your production has not been improved first (i.e. same amount of goods and services in the economy).
This is what we call "inflation". It is the deterioration of money value while goods and services become less and less affordable due to rising price. Let's assume you have $10. Before, you can purchase 10 pens, but inflation arrives, and now, you might be able to purchase only 5 pens with your $10. So before, $1 = 1 pen, but now, inflation strikes, and $1 = 0.5 pen. So the real economic value of your money is decreasing by half. ouch!
So printing more money can lead to inflation, a "demand-pull inflation" to be precise. That means the higher price is caused by the rapid increase in demand within an economy (while the supply level does not change).
In short, you cannot eat and drink money, but it is, without doubt, one of the foundations of a strong and vibrant modern economy. Its importance is undeniable. However, printing more money is not going to make you any richer in real term because like I said, money is just a medium of exchange. If you are crossing a river, having more boats is not going to speed things up for you, is it? But it will, it will if and only if you have lots of friends and stuffs to be transported.
I will provide further explanation including the negative impacts of printing money within an economy in PART 2.
It turns out money is just a medium of exchange, and that, the whole economy is anchored on products and services it produces. So to explain this economic phenomenon, let's just forget about money. The wealth of a nation is not the amount of money it has, but the amount of total outputs it generates and accumulates. After all, you would not survive with a million bucks if you were in the middle of Sahara desert. True, don't you think? Because the amount of goods and services Sahara desert has to offer is virtually ZERO. Thus, I guess (and I am pretty sure) that you would be willing to pay a truckload of cash (Benjamins), let alone a million dollars, for just a bottle of water. How can it be so expensive? Because it is so scarce, so rare to be found, in Sahara that a bottle of water is worth any amount of money you can possibly imagine. This means that its price is merely a signal of the scarcity and the demand for water. If you think of it this way, I guess it will help you to better grasp the concept of economics, especially money.
If a nation prints 10 millions more of $100 bill, it does not necessarily mean that its people are now any better off than how they used to be. Look at it this way, if a poor country suddenly prints more money, but it still produces the same amount of outputs with no increase in employment or natural resources, that country, technically, is still poor in real economic sense. So what are the outcomes of having more money but same level of goods and services within an economy?
Imagine living in a small village with no apple tree, no apple import (i.e. a closed economy). While walking, you kick a genie, woke him up, and the genie now grants you 1 wish. Where are the other 2 wishes? Well, I wouldn't grant you 3 wishes, let alone 1, if you kicked me. He is just too kind. Anyway, now you ask him to bestow upon you, 2 apples (who needs a billion bucks, or even better a huge mansion with unlimited wealth inside, when you can have free apples?). You now have become the only person in the entire village to own 2 apples. Now everyone, especially the rich, would be willing to pay you high price, say $1000 just for a bite. I meant they have never tasted apple before. Until, someone else kicks the genie again, and ask for a billion apples (That is why maths is important because by studying maths, you can count more than 2). All of a sudden, your 2 apples are now worthless because the village now has tons of apples on its hand that it does not even know what to do with them.
This specific scenario, as described above, should be quite similar in nature, and thus, comparable to reality. Money and apple are two different things, but the law of supply and demand are applicable to both items. When apple supply spikes, its value depreciates/declines. When money supply increases (while the output produced remains unchanged), its value will simply fall. In other words, as people get more money in hands, they feel richer, and as a result, they start to demand and consume (buy) more. The demand for goods and services rise, but since the quantity of output is the same as before (remember, we only print more money, NOT produce more), then high demand will turn into a competition, thus bid up the price of each good and service. Simply put, people, who are now richer as a result of having more money within circulation, are not afraid to spend. They compete to get what they want, and in doing so, they either directly or indirectly raise price in the economy. The golden rule is when something is strongly desired by everyone, its value appreciates/rises.
I will give you another example just for fun. You bake a pie, and you hand out 2 tickets to people, each worth half a pie. Now suppose, instead of handing out 2 tickets, you hand out a thousand tickets. Each ticket is now almost worthless because each can only be exchanged for a really really thin slice of pie (1/1000 pie). This is what printing more money does to you when your production has not been improved first (i.e. same amount of goods and services in the economy).
This is what we call "inflation". It is the deterioration of money value while goods and services become less and less affordable due to rising price. Let's assume you have $10. Before, you can purchase 10 pens, but inflation arrives, and now, you might be able to purchase only 5 pens with your $10. So before, $1 = 1 pen, but now, inflation strikes, and $1 = 0.5 pen. So the real economic value of your money is decreasing by half. ouch!
So printing more money can lead to inflation, a "demand-pull inflation" to be precise. That means the higher price is caused by the rapid increase in demand within an economy (while the supply level does not change).
In short, you cannot eat and drink money, but it is, without doubt, one of the foundations of a strong and vibrant modern economy. Its importance is undeniable. However, printing more money is not going to make you any richer in real term because like I said, money is just a medium of exchange. If you are crossing a river, having more boats is not going to speed things up for you, is it? But it will, it will if and only if you have lots of friends and stuffs to be transported.
I will provide further explanation including the negative impacts of printing money within an economy in PART 2.
Saturday, January 11, 2014
Wage hike and its implication
"I would like to, first of all, declare that I have no political agenda, no political incentive or whatsoever to write any article in favour of any politician. This is democracy, and I live under freedom of speech. I believe it is my right to voice out my opinions, under the laws as the binding force, (as long as they cause no harm or damage towards the others) should I choose to. Anyone who scorns, threatens and ridicules anyone else (for expressing his/her opinion) on groundless rationale shall never call him/herself pro-democracy."
Regardless, wage raising does not have anything to do with politics in the first place. Those people just use it as a means to achieve their ends. Balancing wage and growth is all about Economics, pure economics I say.
To start off, understanding the nature of economics is crucial. People are delighted by good intention and promising ends/goals. However, living in an ideal world is a blindness, not to mention choosing to do it perversely. Reality is full of suffering, but by accepting reality, we can at least suffer and move forward having a chance to find an oasis. It is much better than playing pretense. You have to understand that in this world, perfection does not exist. You cannot expect a good life without a tradeoff. It does not work this way. Nothing is free because everything entails a cost. The right question to ask is what is the cost of this or that particular decision? At what cost is the decision to indulge the entire economy in a short-term prosperity, something you deem righteous and just?
A simple and naive mind would look at the economic systems and policies and sees only the goals they pursue. Economics, however, is more about the incentive those decisions create. In other words, the consequences are the main concern, not the intention. A good intention, the act of philanthropy, that will cause ruinous damage later on is nothing but evil. Despite the fact that it is done out of love, feeding your kids McDonald everyday until they become fat kids is not a good thing, is it? No, I do not think so. Of course, they might be enjoying this special treat everyday until it becomes an addiction, a sickness of the mind. But how long will it last? How long will it take until they realize that obesity will strike them in the face as they become teenagers/adults. Economic systems and policies are no different. Some policies look desirable, and it might yield a favorable outcome in the short-term, but just before you know it, it will become a disease, a long-term adversity to our economy.
All else constant, wage raising is not negative per se. Wage raising is good when the economy is growing because it will offset the inflation effect (rising price) and at the same time, synchronize with the rising productivity. Increasing wage will increase the standard of living, and as people with higher income are likely to spend more (demand more), it allows no excess in the market economy, increases demand for more goods and services, creates more jobs, more houses... more stuffs (long-term prosperity you are witnessing here!). It will also enable shifting to a middle-class society where a majority of people live with sufficient income to serve their basic needs and afford amenities of life. They will probably still have some saving which will turn into investment either directly or indirectly via loan.
However, a joke (about monkey stealing people's pants) that seems to be hilarious during your happy family dinner time might have a different taste and outcome when you tell it to your boss whose pants have just been stolen by a monkey (and are now pantless). He would be quite upset I suppose, and you might be sacked. The economy is no different. A once seemingly great policy (wage raise) when the economy is shooting up might cause a major crisis when implementing it under different circumstances, not limiting to a depressed economy.
Now I will give you an example, a scenario in which wage raising, or should I say "wage hike", is most likely a regrettable decision. That is to say, a change is okay, but a drastic change is not. Assuming you have a least-developed country, Poorland, whose garment industry is one of its economic backbones. First, we must define "garment industry". Garment industry, as far as I know, has always been a low-wage industry, and to say any differently is opposing reality. But does that mean that it should stay this way forever? No. However, an abrupt wage hike without any understanding the possible repercussions is not the right approach either.
As defined, garment industry, by today's standard, is a low-wage industry. The human-to-machine ratio is not that great, and thus, the productivity is mostly limited to the innate capability of human. After all, the garment industry is a labour intensive one by nature. What does this tell us? This tells us that a wage hike in Poorland will significantly lower its competitiveness in this specific sector compared to other countries. So the first apparent effect is the movement of garment industries from Poorland to countries with lower wages. Second, garment exports will also decrease sharply which will hurt the national economy. So the people are the ones to suffer when we lose more and more jobs.
Another impact is the inability of the garment industry to hire mass labor as it used to. I am assuming that each factory's owner is a profit-seeking individual (which is a rational way to look at it). So this will compels them to layoff some workers, and keep and employ only the best they could find. Those whose skills and productivity are relatively low will be dismissed. They can also retain every worker, but they might have to raise price and cut back some benefits their workers might have otherwise received. Again, any increase in price will lower their competitiveness. Another way is to endure lower net earning and live with it, but that means lower saving and investment for the whole economy. Plus, if they were to earn less, it would not make sense for them to stay anyway. As long as there is a substitution of labour force in another country, they are always able to relocate their factories.
Remember what I said about productivity. If your whole economy can produce 1 apple and $1, then an apple will be $1. When the economy still has 1 apple and wage rise to $2, then an apple will be $2. You are not better off because you still only get 1 apple. What about the others whose wages were not raised and sill receive $1? They can now only afford half an apple. Should we also raise wage for them too? Should we play the inflation (rising price) game? The problem is the higher the wage a company has to pay its worker, the more likely it would to retain its skilled worker and reluctant to accept new and unskilled ones. This means that wage hike will help the incumbents, but the unemployed/entrants will probably suffer pretty badly. Since rising wage can also transform to rising price (cost passed on to consumers), those whose wages remain fixed will suffer greatly, especially the unemployed who now find everything else less affordable.
But what worries me the most is the unbalanced urban-bound migration and simply mass job switching from agricultural sector towards labour-intensive industrial sector heavily centralized in traditionally low-wage garment industry, which will be economically unsustainable in the long run. First of all, it has to do with rising price of agricultural products because as more young farmers come to seek a better paid job within the city due to minimum wage hike, there will be less and less farmers to produce rice, fruit, meat and so forth. Furthermore, the higher wage for unskilled labour will most likely attract workers from many other industries causing labour shortage in those industries, not to mention upward pressure for the wages in those other industries and downward pressure on the wages in garment industry to keep everything within balance. However, with the minimum wage hike, there would be no room to move. This might lead to higher production cost and eventually higher price. Higher price? Yes. Why? Because we have the wrong impression of the economy. The economy, like I said again and again, is not better off having more money. That is nonsense. The economy is only better off having more goods and services. By forcing higher wages on garment industry, we are sucking up supply of agricultural products in exchange for supply of clothes. However, PoorLand has better potential in agriculture, and poverty means more demand for food, less for clothes. So by instantly switching to labour-intensive industry, a few will gain while most will have to endure the heavy burden. And since minimum wages will drain workers away from other industries/businesses who cannot afford to raise wages, this negative outcome will most likely strike small and medium enterprise who will now struggle to find employees/labour. Though this might sound ridiculous, wage hike (drastic wage increase) can also discourage education among the poor, as better paid unskilled labour look more and more alluring, and the present demand prevails over that of the future.
More than that, wage hike makes it hard for employers to adjust during economic downturn. Do you know something called "ratchet effect"? It is this inability of human to reverse once a specific thing has happened. In other words, with higher minimum wage, the employers might find it hard to press it down when the economy is experiencing a recession because workers are most likely to resist any effects regressing them towards their former condition/state. This will force employers to layoff workers. So instead of everyone having a little bit of something, we now have some people with more and some with none.
If you ask me, is this fair? is this justice? No. No, this is not fair, but if you can convince the rest of the world to cut back on profit and suck on higher price to ensure level playing field, then raising wage is sound idea . However, by blindly trying to increase wage without realizing the cost, one might end up with nothing at all, or even worse, a decline.
Be careful not to let the minimum wage exceeds the market wage. This will spell out in a disastrous result. However, assuming it does not exceed the market wage, the free market dictates that the employers have the right to desire profitable business. Forcing them to reduce their profit is probably not that easy, but they might agree to raise wage by cutting back on something else (i.e. at a cost).
An abrupt wage hike can also increase the risk premium within a country, that is to say, it will lower the country's credibility (thus, investment confidence which is hard to retain and regain). As a consequence, investors might demand higher interest rate or rate of return for their loan or investment, and they will be less likely to consider PoorLand as a potential investment target, which will hurt the economy badly in the long run as the total loss, if future loss is to be added, might outstrip the benefits of wage hike.
Of course, increasing minimum wages also has huge positive impacts which can offset the negatives. For instance, it can be a form of extrinsic motivation, increase consumption (thus spending which is good for the economy as long as it is at an appropriate level, which as mentioned, in proportion to the rise in productivity), force the employers to focus on efficiency and increase capital-human ratio to transform garment industry to being more capital-intensive, encourage participation in the workforce (workers in formal sector > workers in informal sector ===> more tax revenue for the government ===> allow for more spending on public service and so forth), lower government social net spending, just to name a few. However, it should never be generalized, i.e. it does not apply to every industry. A smooth and well-coordinated transition is needed.
What I would suggest here is to boost real income by focusing on the supply side. Agricultural production, Physical infrastructure, capacity building (vocational training, etc), and various governmental institutions (especially one of education) should be the key factors to be focused to ensure long-term sustainable growth. Demand side (i.e. raising wage) should be stimulated only when there is sufficient and appropriate level of supply to buffer the potential negative impacts.
All in all, wage is not an ends. Job is not either. Having enough food, warm shelter, and decent living standard are what we need. Objectively speaking, a great policy is not the one that pleases the most people, it is the one with most positive impacts that can offset the cost (negative effects) it incurs. So before implementing a policy, it requires great understanding and rigorous research of the economy. However, research on different countries yield different results. We should gather our experience from international best practice, but PoorLand should not look at research on minimum wage policy in RichLand whose characteristics differ greatly from PoorLand's. PoorLand should instead study any research relevant to wage policy in another developing or least-developed nation.
Regardless, wage raising does not have anything to do with politics in the first place. Those people just use it as a means to achieve their ends. Balancing wage and growth is all about Economics, pure economics I say.
To start off, understanding the nature of economics is crucial. People are delighted by good intention and promising ends/goals. However, living in an ideal world is a blindness, not to mention choosing to do it perversely. Reality is full of suffering, but by accepting reality, we can at least suffer and move forward having a chance to find an oasis. It is much better than playing pretense. You have to understand that in this world, perfection does not exist. You cannot expect a good life without a tradeoff. It does not work this way. Nothing is free because everything entails a cost. The right question to ask is what is the cost of this or that particular decision? At what cost is the decision to indulge the entire economy in a short-term prosperity, something you deem righteous and just?
A simple and naive mind would look at the economic systems and policies and sees only the goals they pursue. Economics, however, is more about the incentive those decisions create. In other words, the consequences are the main concern, not the intention. A good intention, the act of philanthropy, that will cause ruinous damage later on is nothing but evil. Despite the fact that it is done out of love, feeding your kids McDonald everyday until they become fat kids is not a good thing, is it? No, I do not think so. Of course, they might be enjoying this special treat everyday until it becomes an addiction, a sickness of the mind. But how long will it last? How long will it take until they realize that obesity will strike them in the face as they become teenagers/adults. Economic systems and policies are no different. Some policies look desirable, and it might yield a favorable outcome in the short-term, but just before you know it, it will become a disease, a long-term adversity to our economy.
All else constant, wage raising is not negative per se. Wage raising is good when the economy is growing because it will offset the inflation effect (rising price) and at the same time, synchronize with the rising productivity. Increasing wage will increase the standard of living, and as people with higher income are likely to spend more (demand more), it allows no excess in the market economy, increases demand for more goods and services, creates more jobs, more houses... more stuffs (long-term prosperity you are witnessing here!). It will also enable shifting to a middle-class society where a majority of people live with sufficient income to serve their basic needs and afford amenities of life. They will probably still have some saving which will turn into investment either directly or indirectly via loan.
However, a joke (about monkey stealing people's pants) that seems to be hilarious during your happy family dinner time might have a different taste and outcome when you tell it to your boss whose pants have just been stolen by a monkey (and are now pantless). He would be quite upset I suppose, and you might be sacked. The economy is no different. A once seemingly great policy (wage raise) when the economy is shooting up might cause a major crisis when implementing it under different circumstances, not limiting to a depressed economy.
Now I will give you an example, a scenario in which wage raising, or should I say "wage hike", is most likely a regrettable decision. That is to say, a change is okay, but a drastic change is not. Assuming you have a least-developed country, Poorland, whose garment industry is one of its economic backbones. First, we must define "garment industry". Garment industry, as far as I know, has always been a low-wage industry, and to say any differently is opposing reality. But does that mean that it should stay this way forever? No. However, an abrupt wage hike without any understanding the possible repercussions is not the right approach either.
As defined, garment industry, by today's standard, is a low-wage industry. The human-to-machine ratio is not that great, and thus, the productivity is mostly limited to the innate capability of human. After all, the garment industry is a labour intensive one by nature. What does this tell us? This tells us that a wage hike in Poorland will significantly lower its competitiveness in this specific sector compared to other countries. So the first apparent effect is the movement of garment industries from Poorland to countries with lower wages. Second, garment exports will also decrease sharply which will hurt the national economy. So the people are the ones to suffer when we lose more and more jobs.
Another impact is the inability of the garment industry to hire mass labor as it used to. I am assuming that each factory's owner is a profit-seeking individual (which is a rational way to look at it). So this will compels them to layoff some workers, and keep and employ only the best they could find. Those whose skills and productivity are relatively low will be dismissed. They can also retain every worker, but they might have to raise price and cut back some benefits their workers might have otherwise received. Again, any increase in price will lower their competitiveness. Another way is to endure lower net earning and live with it, but that means lower saving and investment for the whole economy. Plus, if they were to earn less, it would not make sense for them to stay anyway. As long as there is a substitution of labour force in another country, they are always able to relocate their factories.
Remember what I said about productivity. If your whole economy can produce 1 apple and $1, then an apple will be $1. When the economy still has 1 apple and wage rise to $2, then an apple will be $2. You are not better off because you still only get 1 apple. What about the others whose wages were not raised and sill receive $1? They can now only afford half an apple. Should we also raise wage for them too? Should we play the inflation (rising price) game? The problem is the higher the wage a company has to pay its worker, the more likely it would to retain its skilled worker and reluctant to accept new and unskilled ones. This means that wage hike will help the incumbents, but the unemployed/entrants will probably suffer pretty badly. Since rising wage can also transform to rising price (cost passed on to consumers), those whose wages remain fixed will suffer greatly, especially the unemployed who now find everything else less affordable.
But what worries me the most is the unbalanced urban-bound migration and simply mass job switching from agricultural sector towards labour-intensive industrial sector heavily centralized in traditionally low-wage garment industry, which will be economically unsustainable in the long run. First of all, it has to do with rising price of agricultural products because as more young farmers come to seek a better paid job within the city due to minimum wage hike, there will be less and less farmers to produce rice, fruit, meat and so forth. Furthermore, the higher wage for unskilled labour will most likely attract workers from many other industries causing labour shortage in those industries, not to mention upward pressure for the wages in those other industries and downward pressure on the wages in garment industry to keep everything within balance. However, with the minimum wage hike, there would be no room to move. This might lead to higher production cost and eventually higher price. Higher price? Yes. Why? Because we have the wrong impression of the economy. The economy, like I said again and again, is not better off having more money. That is nonsense. The economy is only better off having more goods and services. By forcing higher wages on garment industry, we are sucking up supply of agricultural products in exchange for supply of clothes. However, PoorLand has better potential in agriculture, and poverty means more demand for food, less for clothes. So by instantly switching to labour-intensive industry, a few will gain while most will have to endure the heavy burden. And since minimum wages will drain workers away from other industries/businesses who cannot afford to raise wages, this negative outcome will most likely strike small and medium enterprise who will now struggle to find employees/labour. Though this might sound ridiculous, wage hike (drastic wage increase) can also discourage education among the poor, as better paid unskilled labour look more and more alluring, and the present demand prevails over that of the future.
More than that, wage hike makes it hard for employers to adjust during economic downturn. Do you know something called "ratchet effect"? It is this inability of human to reverse once a specific thing has happened. In other words, with higher minimum wage, the employers might find it hard to press it down when the economy is experiencing a recession because workers are most likely to resist any effects regressing them towards their former condition/state. This will force employers to layoff workers. So instead of everyone having a little bit of something, we now have some people with more and some with none.
If you ask me, is this fair? is this justice? No. No, this is not fair, but if you can convince the rest of the world to cut back on profit and suck on higher price to ensure level playing field, then raising wage is sound idea . However, by blindly trying to increase wage without realizing the cost, one might end up with nothing at all, or even worse, a decline.
Be careful not to let the minimum wage exceeds the market wage. This will spell out in a disastrous result. However, assuming it does not exceed the market wage, the free market dictates that the employers have the right to desire profitable business. Forcing them to reduce their profit is probably not that easy, but they might agree to raise wage by cutting back on something else (i.e. at a cost).
An abrupt wage hike can also increase the risk premium within a country, that is to say, it will lower the country's credibility (thus, investment confidence which is hard to retain and regain). As a consequence, investors might demand higher interest rate or rate of return for their loan or investment, and they will be less likely to consider PoorLand as a potential investment target, which will hurt the economy badly in the long run as the total loss, if future loss is to be added, might outstrip the benefits of wage hike.
Of course, increasing minimum wages also has huge positive impacts which can offset the negatives. For instance, it can be a form of extrinsic motivation, increase consumption (thus spending which is good for the economy as long as it is at an appropriate level, which as mentioned, in proportion to the rise in productivity), force the employers to focus on efficiency and increase capital-human ratio to transform garment industry to being more capital-intensive, encourage participation in the workforce (workers in formal sector > workers in informal sector ===> more tax revenue for the government ===> allow for more spending on public service and so forth), lower government social net spending, just to name a few. However, it should never be generalized, i.e. it does not apply to every industry. A smooth and well-coordinated transition is needed.
What I would suggest here is to boost real income by focusing on the supply side. Agricultural production, Physical infrastructure, capacity building (vocational training, etc), and various governmental institutions (especially one of education) should be the key factors to be focused to ensure long-term sustainable growth. Demand side (i.e. raising wage) should be stimulated only when there is sufficient and appropriate level of supply to buffer the potential negative impacts.
All in all, wage is not an ends. Job is not either. Having enough food, warm shelter, and decent living standard are what we need. Objectively speaking, a great policy is not the one that pleases the most people, it is the one with most positive impacts that can offset the cost (negative effects) it incurs. So before implementing a policy, it requires great understanding and rigorous research of the economy. However, research on different countries yield different results. We should gather our experience from international best practice, but PoorLand should not look at research on minimum wage policy in RichLand whose characteristics differ greatly from PoorLand's. PoorLand should instead study any research relevant to wage policy in another developing or least-developed nation.
Monday, December 30, 2013
Understanding "Multiplier"
-So many topics to choose, so much time to write. The moral of the story is: I am lazy.-
In our very first article of this blog, we mentioned about the misconception of economics, the fact that 99.5% of the entire population thinks of an economy solely in term of money. Where did I get the data? I made it up. That is what economists do daily. Make things up. Actually, that is another one of the widespread misguided belief. It is true that 99.5% is just a made-up number, but you should be able to grasp what I meant. The vast majority (a vague but somehow a justifiable and easy-to-use cliché, "vast majority") of people still think of economics as a not-so-scientific-bedtime story about money. WRONG, I said (and a bunch other economists said)!
So before we begin, let us clear our mind of all the preconceived notions we once held about economics. Economics is not about money, but it is more about converting scarce resources, which have alternative uses, to outputs. Actually, I would prefer it if you associate economics with outputs. Though it is not the perfect proxy, it is still much more suitable, especially in the context of today's discussion about Multiplier.
I have already mentioned about the virtue and vice of spending, but now, let us focus on the good side. If this is the first time you hear "Multiplier", you are probably thinking about multiplication, and you are right. Multiplier multiplies. It does not get any simpler than this. Multiplier multiplies spending.
Wait, what? Multiplies spending?
Yes, you read it right. You do not need your glasses yet. In economics, a $100 spent by Mr.A is not a $100 received by the economy. This is not business 101. Forget about business and accounting, this is Economics 101.
In an economy, spending $100 will get you either more or less, but almost always, especially in a robust economy, you get more. This very idea justifies and advocates government spending (the use of stimulus packages, etc), and most of the time, encourages the government to run deficits (i.e. spend even if it exceeds their earning, meaning borrow to spend) in accordance with Keynesian economics in which multiplier is most used and accredited.
The idea is that spending money or injecting money into circulation within an economy will generate even more money, or to be more specific (and correct), value of outputs. As long as the first recipient of the $100 (from whoever spent it) continues the tradition by spending a portion, no matter how small, of that $100, the economy will receive more than the initial amount ($100) spent. I guess a few, or let be optimistic, some of you, by this point, have already understood the underlying concept that I am trying to explain. To illustrate it further, here is an example:
"Iron man paid $5 to Batman's butler to wash and iron his iron suit (I do not know how that can be done either). Batman's butler, in turn, saved $1 and spent the rest ($4) to buy Batman's favourite pizza from the fast-delivery spidy pizza owned by Spiderman. Spiderman kept $1 (of the $4 he received) in his bank account, and spent the rest ($3) on getting a new and cooler mask. Let us assume that the mask maker (whoever that is, probably the Hulk) saved all the $3 proceeds and stopped the spending chain here."
Now let us re-think of what we get so far from the perspective of the whole economy. What do we have up till now in term of the goods and services produced?
In our very first article of this blog, we mentioned about the misconception of economics, the fact that 99.5% of the entire population thinks of an economy solely in term of money. Where did I get the data? I made it up. That is what economists do daily. Make things up. Actually, that is another one of the widespread misguided belief. It is true that 99.5% is just a made-up number, but you should be able to grasp what I meant. The vast majority (a vague but somehow a justifiable and easy-to-use cliché, "vast majority") of people still think of economics as a not-so-scientific-bedtime story about money. WRONG, I said (and a bunch other economists said)!
So before we begin, let us clear our mind of all the preconceived notions we once held about economics. Economics is not about money, but it is more about converting scarce resources, which have alternative uses, to outputs. Actually, I would prefer it if you associate economics with outputs. Though it is not the perfect proxy, it is still much more suitable, especially in the context of today's discussion about Multiplier.
I have already mentioned about the virtue and vice of spending, but now, let us focus on the good side. If this is the first time you hear "Multiplier", you are probably thinking about multiplication, and you are right. Multiplier multiplies. It does not get any simpler than this. Multiplier multiplies spending.
Wait, what? Multiplies spending?
Yes, you read it right. You do not need your glasses yet. In economics, a $100 spent by Mr.A is not a $100 received by the economy. This is not business 101. Forget about business and accounting, this is Economics 101.
In an economy, spending $100 will get you either more or less, but almost always, especially in a robust economy, you get more. This very idea justifies and advocates government spending (the use of stimulus packages, etc), and most of the time, encourages the government to run deficits (i.e. spend even if it exceeds their earning, meaning borrow to spend) in accordance with Keynesian economics in which multiplier is most used and accredited.
The idea is that spending money or injecting money into circulation within an economy will generate even more money, or to be more specific (and correct), value of outputs. As long as the first recipient of the $100 (from whoever spent it) continues the tradition by spending a portion, no matter how small, of that $100, the economy will receive more than the initial amount ($100) spent. I guess a few, or let be optimistic, some of you, by this point, have already understood the underlying concept that I am trying to explain. To illustrate it further, here is an example:
"Iron man paid $5 to Batman's butler to wash and iron his iron suit (I do not know how that can be done either). Batman's butler, in turn, saved $1 and spent the rest ($4) to buy Batman's favourite pizza from the fast-delivery spidy pizza owned by Spiderman. Spiderman kept $1 (of the $4 he received) in his bank account, and spent the rest ($3) on getting a new and cooler mask. Let us assume that the mask maker (whoever that is, probably the Hulk) saved all the $3 proceeds and stopped the spending chain here."
Now let us re-think of what we get so far from the perspective of the whole economy. What do we have up till now in term of the goods and services produced?
- Batman's butler received the $5 which is the value of his washing and ironing service for Ironman. So we have 1 washing and ironing service produced at $5.
- Spiderman received $4 to make a mouthwatering finger linkin' pizza for batman. So here a pizza was produced in this particular economy at the price of $4.
- The mysterious mask maker (whom I thought might be the Hulk) got paid $3, and he produced a cool-looking mask for spiderman. He just decided to keep it for whatever the reason. So we have a mask produced at the price of $3.
To sum up, the economy has gained:
= a $5 washing and ironing service + a $4 mouthwatering pizza + a $3 mask
= 3 goods and services in total with the value of $12
From this simple example, we have thus proved the point that money spent will generate more than the initial amount for the economy. This is not about money creating money, but this is about money creating outputs which are valued in term of money.
I can safely say (based on the example I made up) that multiplier does exist. If you ever wonder what the value of the multiplier is in our example, just do the maths.
Multiplier = $12 (total outputs)/$5 (initial capital injection or money spent) = 2.4
Now what if the initial spending is $1 million instead of $5?
Using the multiplier, then the total increase in the overall production of goods and services in the economy would be $1million x 2.4 = $2.4 million!
Multiplier is extremely important as it determines the effectiveness of spending in an economy. In a consumerism society, where people save less and spend more, we would expect the multiplier effect to be much stronger than that of the one favouring saving. That is why the same amount of government spending does not yield the same result when applied in different countries across the globe. This is why economic research is crucial in understanding both the short-term and long-term consequences of a policy, for instance, expansionary fiscal policy which is pretty much about government increasing spending.
And that wraps it up for today. Just one last reminder though.
Remember folks, MULTIPLIER is NOT magic.
Wednesday, December 25, 2013
GDP, the economic illusion
A country with high rate of GDP growth is mostly regarded as economically healthy. But is it on the right track of development? Is the growth sustainable? Is GDP a good indicator of prosperity? Is this really the best we can do?
We always think of economic growth in term of GDP - short for Gross Domestic Product. It is basically the total amount of outputs produced domestically by a nation, mostly measured in annual term. GDP is measured in USD. Then we have GDP per capita or GDP per person (GDP divided by total population). These are the most prevalent economic indicators used to date to identify the stage of development in which a country situated. The downside of using GDP to measure development is the fact that it forces people to think of development with reference only to its monetary value. For instance, when a country reaches a certain cut-off, they will move up the rank from, say, low-income nation to lower-middle-income nation, and as a result, most would think that it is now better off. Though this is true in economic sense, this type of classification still misleads our judgement of what development really is.
Imagine this scenario in which a country, Narnia, (with a population of 100) has GDP per capita of $2000. That means that an average Narnian earns about $2000 annually. That is not too bad actually. But what if I tell you that 50 Narnian generates as much as $3900 per year, and the other 50 can manage to earn only $100 per year. Shocking? You should not be. $2000 is the mean income. In fact, you can try doing the math.
$2000 = total income (GDP)/100 = ($3900x50 + $100x50)/100
As mentioned, the calculation does not say anything about the wealthy half of the country and the much poorer half. This much contrast within the society results in what we call "social disparity" (a broad term), or to be more specific, "income inequality".
So the next time you hear Narnia brags about its GDP growth, remember that GDP does not say much about the country. Try asking Aslan about Narnia's Narnian Development Index (Human Development Index) or its GNH, Gross Narnian Happiness. If the scores are too low, you can just return, close the wardrobe, lock it, and never go back. Because now you know that Narnia is not a happy land for you to conquer!
We always think of economic growth in term of GDP - short for Gross Domestic Product. It is basically the total amount of outputs produced domestically by a nation, mostly measured in annual term. GDP is measured in USD. Then we have GDP per capita or GDP per person (GDP divided by total population). These are the most prevalent economic indicators used to date to identify the stage of development in which a country situated. The downside of using GDP to measure development is the fact that it forces people to think of development with reference only to its monetary value. For instance, when a country reaches a certain cut-off, they will move up the rank from, say, low-income nation to lower-middle-income nation, and as a result, most would think that it is now better off. Though this is true in economic sense, this type of classification still misleads our judgement of what development really is.
First of all, development should be clearly defined so to prevent confusion. Development is not about climbing up towards the status of high-income country. Development is not entirely about increasing the GDP. It should not be just about a nation's wealth. Development is the improvement of the general well-being of the people. We do not just want a developed country, but a well-developed country.
So GDP is certainly overrated. GDP is the aggregation of the monetary value of consumption, investment, government spending and net export (export - import). None of its components involves equity, equality, justice, freedom, institutional efficacy, transparency, accountability, health, education, general level of satisfaction, and the list goes on. It does not say anything about income inequality, racial discrimination, corruption, educational inefficacy, etc. GDP might be a good indicator for the aggregate economic growth of a country, but its strength as a development indicator is only moderate, if not weak.
Imagine this scenario in which a country, Narnia, (with a population of 100) has GDP per capita of $2000. That means that an average Narnian earns about $2000 annually. That is not too bad actually. But what if I tell you that 50 Narnian generates as much as $3900 per year, and the other 50 can manage to earn only $100 per year. Shocking? You should not be. $2000 is the mean income. In fact, you can try doing the math.
$2000 = total income (GDP)/100 = ($3900x50 + $100x50)/100
As mentioned, the calculation does not say anything about the wealthy half of the country and the much poorer half. This much contrast within the society results in what we call "social disparity" (a broad term), or to be more specific, "income inequality".
This is why the United Nation developed another development indicator known as Human Development Index (HDI) comprising income, health and education as its elements. This is far from a perfect determinant of development, but still, it is better than solely measuring growth with total output (GDP).
We are constantly seeking a more holistic approach in measuring a country's overall development, especially the welfare of its people. Believe it or not, aside from the HDI, in Bhutan, they have something called GNH or Gross National Happiness (yes, it has been officially used in Bhutan). It is an attempt to determine living standard or life quality by looking beyond the conventional economic measurement of GDP. I guess happiness is a good enough indicator? Who knows?
We are constantly seeking a more holistic approach in measuring a country's overall development, especially the welfare of its people. Believe it or not, aside from the HDI, in Bhutan, they have something called GNH or Gross National Happiness (yes, it has been officially used in Bhutan). It is an attempt to determine living standard or life quality by looking beyond the conventional economic measurement of GDP. I guess happiness is a good enough indicator? Who knows?
So the next time you hear Narnia brags about its GDP growth, remember that GDP does not say much about the country. Try asking Aslan about Narnia's Narnian Development Index (Human Development Index) or its GNH, Gross Narnian Happiness. If the scores are too low, you can just return, close the wardrobe, lock it, and never go back. Because now you know that Narnia is not a happy land for you to conquer!
Sunday, December 22, 2013
Food Waste
In our previous articles, we have talked about earning and spending (i.e. consuming). This time, we will focus on waste, food waste in particular. The leftover we stop or do not consume is either donated (to our dogs, cats, pokemons?... hardly to any human), or most of the time, thrown away in the garbage bin. Food waste, in short, is the food that is not consumed or shared.
So what? Well, Economics says it is bad. Actually, there is nothing positive about wasting food. Here is something you ought to know. At the post-harvest or processing stages, food loss is inevitable due to the strict quality standard (so you do not get sick consuming the final products), or other unexplained factors that are difficult to account for. Still, it is always better if the amount of waste can be reduced.
However, I am not going to discuss about the waste resulting from the supply side. I am more interested in food waste in the demand side of the economy. In other words, I am talking about you and I wasting food. It is estimated that around half of all the food produced is wasted worldwide (2013), and 40% of the waste occurs at the retail and consumer levels. That is a lot. That is almost enough to feed another earth, and yet, millions of people are suffering from chronic hunger (that means you wake up hungry, go to work hungry, and go to sleep hungry).
How much food have you wasted? People like to put plenty on their plate (and sometimes too much), and end up wasting it. They like to stock up their food supply and store them. Preserved food is okay because they can be kept for a long time, but perishable food (like meat and veggies) will be disposed of much much sooner. Sometimes, it is hard to blame anyone, but that does not mean that a change is not needed. Wasting food, in any form at all, is bad at many levels.
Now this is what I want to emphasize, the negative economic effects of wasting food. The apparent impact is that the food is wasted. Yes, wasting, per se, is bad. You waste your money buying the unconsumed food. Technically, in economic sense, the money is not wasted (we already talked about this). Someone will get paid. However, this is not a win-win practice. Haven't we discussed about opportunity cost? You could have used the money for something else. You could have saved, invested, or loaned it. Then again, you might think $4 on a wasted McDonald's burger is negligible, but if you waste every day, then the accumulated amount will be huge! You might be able to buy a house with it. That is just an exaggeration, but you know what I mean.
We do not have infinite food because it is limited by how much we can produce each year, how much resources we have, how much land (arable land) we have, how many farmers we have, etc. Think of it this way. If there are only 2 apples and two people, A and B, in this world, if A consumes an apple and throw the other apple away, then B will get nothing. B will die. Yes, we die if we don't eat. So when we expand this concept to a much larger scale, it still holds true. Though it is not as obvious (since the world is too large, and mass production tricks us into thinking that we have unlimited supply of food), it only requires a little bit of thinking to realize that there really are As and Bs in real world. Of course, when we buy an apple, in reality, there are still so many left for the others to buy. So we do not really see the direct impact. However, buying entails a problem. Buying is pretty much demanding. When there is a demand for something, that something will have value. The more it is demanded, the higher the value it receives. So when people demand (buy) food, food price simply rises. This is fine until they buy too much for themselves (end up wasting the food), and as a result, they are indirectly increasing the food price for everyone else. We might not feel it, but the most vulnerable people (poor people) certainly will. Since 40% of the wasted food is from retailers/consumers, the increase in price should not just be something I imagine. Another problem is at the end of the production chain, which is pretty much about dumping the waste. It is costly, economically and environmentally. Of course, the food itself is not much of a problem because it is mostly compostable. The problem lies in its packages, boxes and so forth. When you think about it, box is made from paper, and where do you get paper? Tree. Yep, so we are simultaneously raising demand for logging, raising prices of other products (since their price also includes the cost of packaging, boxing...).
We are in the 40%, so we should (must) change. Change the habit. Be efficient. Earth may have enough for us to eat and waste, but this is not about the earth. This is not about YOLO either. This is about solving food crisis, something that should not happen providing the resources endowed to us by the nature. The "new normal" should not be food crisis, the "new normal" should be food abundance.
A tiny contribution towards development is much better than a small contribution to degradation. So roll up your sleeves, and start eating efficiently. No YOLO.
Thursday, December 19, 2013
The Economics of Procrastination
I am procrastinating. So the new article will be written tomorrow.
Now you know what procrastination means. You can thank me later.
Now you know what procrastination means. You can thank me later.
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