One of the tough things about supporting a free-market is that socialist and left-leaning thinking tends to monopolize caring about the poor in public discourse. Of course, many of my free-market brethren are not helping the cause because they actually don't care about the poor. Between these two factors, we get a misleading dichotomy that suggests that if you are left-wing you care and if you are right-wing you do not. On the surface, this idea is not entirely without merit. Left-wing individuals advocate having the government give money to poor people. How can they not be more caring than those who do not?
This where we get into the somewhat callous concept of net poverty. I want to stress that I call it callous because if I don't, someone else will, so I might as well just admit that a good chunk of the general public will see it that way. Net poverty is basically all of those that are poor today plus all of those that will be poor in the future. We ignore people who were poor in the past because there is really nothing a current action can do for them. This is a far more inclusive view of poverty and, in my opinion, a far more appropriate one. It realizes that the actions that we take today can either impoverish or aid the people of tomorrow. As such, it is a better method of weighing the pros and cons of any government action.
A net poverty analysis indicates that most government expenditure on charity will actually increase poverty in our society. While it reduces the number of people who are poor today, it also causes a drag on economic growth, which reduces the future affluence of a society. Thus, while the amount of current poverty is reduced, future poverty is increased. Clearly, from the point of view of reducing poverty, government spending is ill-advised.
Of course, there are plausible exceptions to this. What about cases where poverty is passed on by generations and a helping hand might be enough to make a family and its descendants? The response to this is twofold. First, how does a government identify which individuals would benefit from such treatment? A scatter-shot approach will end up slowing growth and creating more future poverty than it will prevent. Second, if the government can locate these people, why can't private organizations do so and offer assistance in return for some sort of future compensation, perhaps in the form of a fraction of that person's life's earnings? Private enterprise should be able to deal with exceptions like this, though it is difficult to discern any empirical data because our society is not designed to put such an onus on private individuals.
Finally, we have to deal with why private charity is so much better than public charity. After all, the money still ends up with the same people. What's the big difference? The difference comes from the message that these activities send. When an individual is choosing to provide private charity, he or she does so of free will, which means he or she has chosen to doing the work necessary to own the money that will in turn be donated. When charity is forced, the individual is having his or her funds diverted away from his or her choice of spending, which makes the individual less likely to work as hard to earn those funds next year. As such, forced charity reduces work done, which is where the claim that it slows growth comes from.
The point is that a right-wing approach is not necessarily less caring. In fact, I would maintain that it does a better job of caring, which is why I support it. People are always going to point out that there are poor people right now that we can be helping, and they are not wrong, but some methods of helping the people of today will hurt the people of tomorrow. Sometimes it is difficult to look in the long run, but if we want to be truly responsible for all those in need in our world, I feel we must.
Friday, June 22, 2007
Sunday, March 11, 2007
Public and Private Expenditures...
There is a traditional dichotomy used when exploring the use of government funding for various projects, at least there is among the classical liberals. Either 1) the project is something people are willing to pay for, in which case government funding is redundant and wasteful or 2) the project is not something people are willing to pay for, in which case they don't want it, so why is the government funding something the people, whose interests it is supposed to represent, do not want? As you've probably noticed, this dichotomy contains no reference to supply, demand, or any other economic watchword. This is not to say it is not logical, but rather that it is not in terms that an economics student finds very helpful.
So how does one go about converting this dichotomy into the language of economists? Let's start by going back to Say's Law. In its simplest form, Say's Law states that supply creates its own demand. Basically, if you don't have something that people want, you are going to have trouble getting them to give you anything. Therefore, demand only exists when your wants are backed by supply. In contrast, supply only exists when the goods that you have are demanded by other people with supply to back their wants. If that's causing you a headache, just refer to the third sentence of this paragraph.
Anyway, people create supply for themselves so that they will be able to demand goods from other people's supply. They seek to create the most possible supply and thus naturally as a whole, create the maximum possible aggregate supply. This, in turn, maximizes the aggregate demand for a country. Thus, a country left to its own devices will maximize its own natural output and so on and so forth.
So what happens when we introduce government investment, or public expenditures? Either the government is producing something people already want, in which case even the most efficient system cannot surpass the natural output that would be created by private spending of the same nature, or the government is producing something that people do not want, in which case they are producing goods that are not as greatly demanded as the market would allocate and are reducing the aggregate demand in the economy. From there, it is a simple logical extension that if aggregate demand is kept below its natural maximum, natural output will stay below its natural maximum.
The effects of natural output being lower are clearly problematic for any policy maker. Inflation sets in sooner, which raises the NAIRU and keeps overall unemployment higher. This is the effect of having larger amounts of public expenditures in the economy, as far as I can logically surmise. Policy makers would be wiser to push for a change in public opinion, and as such buying habits, than to force such changes through higher public expenditures which will result in either higher inflation or unemployment.
So how does one go about converting this dichotomy into the language of economists? Let's start by going back to Say's Law. In its simplest form, Say's Law states that supply creates its own demand. Basically, if you don't have something that people want, you are going to have trouble getting them to give you anything. Therefore, demand only exists when your wants are backed by supply. In contrast, supply only exists when the goods that you have are demanded by other people with supply to back their wants. If that's causing you a headache, just refer to the third sentence of this paragraph.
Anyway, people create supply for themselves so that they will be able to demand goods from other people's supply. They seek to create the most possible supply and thus naturally as a whole, create the maximum possible aggregate supply. This, in turn, maximizes the aggregate demand for a country. Thus, a country left to its own devices will maximize its own natural output and so on and so forth.
So what happens when we introduce government investment, or public expenditures? Either the government is producing something people already want, in which case even the most efficient system cannot surpass the natural output that would be created by private spending of the same nature, or the government is producing something that people do not want, in which case they are producing goods that are not as greatly demanded as the market would allocate and are reducing the aggregate demand in the economy. From there, it is a simple logical extension that if aggregate demand is kept below its natural maximum, natural output will stay below its natural maximum.
The effects of natural output being lower are clearly problematic for any policy maker. Inflation sets in sooner, which raises the NAIRU and keeps overall unemployment higher. This is the effect of having larger amounts of public expenditures in the economy, as far as I can logically surmise. Policy makers would be wiser to push for a change in public opinion, and as such buying habits, than to force such changes through higher public expenditures which will result in either higher inflation or unemployment.
Friday, February 23, 2007
On China's Currency
This is a brief summary of the effect of a fixed exchange rate between the Chinese and American currencies.
A currency fixed to another currency must have the same interest rates as the other currency. This is derived from expected interest rate parity. In a simplistic model, (the real one uses the same factors with slight modifications that don't change smaller number like the ones I'm using), if a one year bond in China returns 5% and one in America returns 7%, the assumption is that investors expect the Chinese Yuan to appreciate by 2% over the next year. Thus, when converted into American dollars, the Chinese one year bond would return its 5% plus 2% more than it would have last year, for a total of 7%, or the American rate of return. The return on the one bond, plus the additional value the currency has gained over the year, must equal the return on the other bond. Now, if the expected appreciation/depreciation is set at 0%, the Chinese interest rate, ignoring risk, must match the American interest rate. Basically, if you remove the additional value part of the equation from the, well, equation, all the remains are two equal interest rates. After all, if the Chinese interest rate stays at 5% with the American rate at 7%, no one will buy Chinese bonds because the American return is better. This will drive down the price of Chinese bonds on the market, which will increase the difference between the initial outlay and the face value. In turn, this will increase the percentage return on the bond until it reaches parity with the American bond.
In the past, the Chinese Yuan had been fixed to the American dollar. In order to maintain parity, its interest rate on similar bonds, ignoring risk, was the same. The same situation is continuing, except with China's currency fixed to a basket of currencies. The theory is the same, so for simplicity's sake we will work under the assumption that China's currency is fixed just to the American rate.
So what is China's lack of control over its interest rate doing to its economy? When any country gives up control over its interest rate, it loses the ability to speed up or slow down the economy as necessary. It is common to read that the Bank of Canada will raise interest rates to slow down the economy, or raise them to encourage growth. The problem is that China..s growth rate is vastly different than America's. In fact, the difference is about 4%, on average. This is the difference between the growth of Canada in the Depression and the average European country in the 1990's. In other words it's huge. So, while the US is keeping interest rates low to make sure its economy continues to grow, the Chinese interest rates are actually too low given the current rate of growth. The Chinese economy will grow too fast.
Basically, on a more local level, the average Chinese person will want to borrow more and save less when the country's interest rates are below where they should be. After all, if equilibrium interest is the rate where the willingness to borrow matches the willingness to lend and your country's rate is below equilibrium, the market won't clear under normal circumstances. Instead, the central bank has to finance additional lending so that the absence of lenders does not force the interest rate back up and break the fixed exchange rate. The only way the country can do this is to use contractionary fiscal policy (raising taxes or cutting spending) or expansionary monetary policy (printing more money).
Contractionary fiscal policy would see the government raise taxes or decrease spending so that the average person in China has less money. If they have less money, they cannot spend as much, which slows the economy down. In turn, this provides fewer opportunities for growth and discourages people from borrowing money. After all, if there is less demand for a product, its maker is less likely to borrow the money to expand the plant that makes it. The idea is to reduce the willingness to borrow in the market, and thus restore equilibrium. Clearly, this solution would be undesirable. The whole idea behind fixing the currency was to encourage an increase in output, which contractionary policy would completely undo.
This leaves an expansionary monetary policy. Expansionary monetary policy, rather than reducing willingness to borrow, increases the willingness to lend. The government prints new money and acts as a massive creditor for the people to maintain a market-clearing equilibrium. Thus, the money supply is greatly expanded. However, since the increase in the demand for money is not matched by an increase in the productivity of the economy, the expansion of the money supply would be purely inflationary.
This is the policy that China is currently pursuing. While it has resulted in short term growth, the long-term effects will be inflationary pressures that will discourage investment in the Chinese economy. Thus, China's policies will eventually lead to a poorer nation than had they allowed the currency to remain floating on the markets. This is the inherent cost of fixing one's currency instead of letting the market rate determine value.
So what can you do to maximize your returns on the Chinese currency? Well at some point the government will have to fight inflation. That will require them to raise the interest rates to bring prices down. Based on the parity established, the exchange rate will have to decrease, causing the Yuan to appreciate. If one were to buy a Chinese bond today, that person would get the same rate of return as the American bond and, if appreciation occurred before maturity, would receive additional payments when the bond was converted back into US currency at its higher price. In conclusion, it would be advisable for one to buy Chinese bonds now and sell them when the Yuan inevitably appreciates.
A currency fixed to another currency must have the same interest rates as the other currency. This is derived from expected interest rate parity. In a simplistic model, (the real one uses the same factors with slight modifications that don't change smaller number like the ones I'm using), if a one year bond in China returns 5% and one in America returns 7%, the assumption is that investors expect the Chinese Yuan to appreciate by 2% over the next year. Thus, when converted into American dollars, the Chinese one year bond would return its 5% plus 2% more than it would have last year, for a total of 7%, or the American rate of return. The return on the one bond, plus the additional value the currency has gained over the year, must equal the return on the other bond. Now, if the expected appreciation/depreciation is set at 0%, the Chinese interest rate, ignoring risk, must match the American interest rate. Basically, if you remove the additional value part of the equation from the, well, equation, all the remains are two equal interest rates. After all, if the Chinese interest rate stays at 5% with the American rate at 7%, no one will buy Chinese bonds because the American return is better. This will drive down the price of Chinese bonds on the market, which will increase the difference between the initial outlay and the face value. In turn, this will increase the percentage return on the bond until it reaches parity with the American bond.
In the past, the Chinese Yuan had been fixed to the American dollar. In order to maintain parity, its interest rate on similar bonds, ignoring risk, was the same. The same situation is continuing, except with China's currency fixed to a basket of currencies. The theory is the same, so for simplicity's sake we will work under the assumption that China's currency is fixed just to the American rate.
So what is China's lack of control over its interest rate doing to its economy? When any country gives up control over its interest rate, it loses the ability to speed up or slow down the economy as necessary. It is common to read that the Bank of Canada will raise interest rates to slow down the economy, or raise them to encourage growth. The problem is that China..s growth rate is vastly different than America's. In fact, the difference is about 4%, on average. This is the difference between the growth of Canada in the Depression and the average European country in the 1990's. In other words it's huge. So, while the US is keeping interest rates low to make sure its economy continues to grow, the Chinese interest rates are actually too low given the current rate of growth. The Chinese economy will grow too fast.
Basically, on a more local level, the average Chinese person will want to borrow more and save less when the country's interest rates are below where they should be. After all, if equilibrium interest is the rate where the willingness to borrow matches the willingness to lend and your country's rate is below equilibrium, the market won't clear under normal circumstances. Instead, the central bank has to finance additional lending so that the absence of lenders does not force the interest rate back up and break the fixed exchange rate. The only way the country can do this is to use contractionary fiscal policy (raising taxes or cutting spending) or expansionary monetary policy (printing more money).
Contractionary fiscal policy would see the government raise taxes or decrease spending so that the average person in China has less money. If they have less money, they cannot spend as much, which slows the economy down. In turn, this provides fewer opportunities for growth and discourages people from borrowing money. After all, if there is less demand for a product, its maker is less likely to borrow the money to expand the plant that makes it. The idea is to reduce the willingness to borrow in the market, and thus restore equilibrium. Clearly, this solution would be undesirable. The whole idea behind fixing the currency was to encourage an increase in output, which contractionary policy would completely undo.
This leaves an expansionary monetary policy. Expansionary monetary policy, rather than reducing willingness to borrow, increases the willingness to lend. The government prints new money and acts as a massive creditor for the people to maintain a market-clearing equilibrium. Thus, the money supply is greatly expanded. However, since the increase in the demand for money is not matched by an increase in the productivity of the economy, the expansion of the money supply would be purely inflationary.
This is the policy that China is currently pursuing. While it has resulted in short term growth, the long-term effects will be inflationary pressures that will discourage investment in the Chinese economy. Thus, China's policies will eventually lead to a poorer nation than had they allowed the currency to remain floating on the markets. This is the inherent cost of fixing one's currency instead of letting the market rate determine value.
So what can you do to maximize your returns on the Chinese currency? Well at some point the government will have to fight inflation. That will require them to raise the interest rates to bring prices down. Based on the parity established, the exchange rate will have to decrease, causing the Yuan to appreciate. If one were to buy a Chinese bond today, that person would get the same rate of return as the American bond and, if appreciation occurred before maturity, would receive additional payments when the bond was converted back into US currency at its higher price. In conclusion, it would be advisable for one to buy Chinese bonds now and sell them when the Yuan inevitably appreciates.
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