Tuesday, September 30, 2008

Resources for "Current Events"

Here are a few more resources that I think you may find useful when discussing how we got to the current events. Some of them are more than you want for student use, but all of them provide some sense of background and/or perspective on current issues.

The first has actually been available since May of this year. Those of you familiar with the National Public Radio (NPR) program, This American Life, may have already heard this episode on "The Giant Pool of Money". You can listen to the episode or go for the free transcript (as I did). There's not a lot of data there, but the anecdotes are valuable - similar to what you would find in a book reviewed on this blog earlier, this summer, Confessions of a Subprime Lender. But the final point is important. There's lots of blame to go around.

The second resource popped up last week. Harvard University held a Financial Markets Roundtable on the situation last Thursday and included several prominent faculty members in the discussion. The program is long - over 90 minutes - but very informative. I did wish for fewer normative and more positive statements. But in asking for observations on policy, the door of politics gets opened. You can find a link to the realplayer video at the Econlog blog. Just click on "Harvard."

Finally, for those of you who wonder if there's any value-added from computer/video games in our world of economics. Someone took a chart of U.S. Home Prices from 1890 - 2007, adjusted for inflation, and applied it the computer game Roller Coaster Tycoon. Here's the result. (HT to Mark Perry at his Carpe Diem blog).

I look forward to your comments.

Friday, September 26, 2008

Video Resource on the Current Situation

Here's a very clear illustration of how defaults on mortgages have morphed into something much larger. It's worth a look.

(HT to fellow blogger Mike Fladlien at Mikeroeconomics.)

Thursday, September 25, 2008

Interdependence, Externalities and the “Credit Crunch.”

There is a silver lining around the dark cloud hanging over the U.S. economy recently. It should increase interest in your course. I don't know about where you work, but students and staff members around here are talking to me more frequently; even if it's in a light-hearted way.

But as I read and listen to news, commentary and conversations, I'm struck by one fact. There's an overarching view of "us" and "them"; and the "us" gets reparsed and redefined as often as the "them." But it is always in a way that the speaker is among the "us" and, more importantly feels put upon by the "thems", however defined. What seems to be missing is a sense or understanding of the concept of interdependence – we’re all "them" AND "us." Allow me to illustrate.

This article from The Washington Post is not atypical of a lot of recent coverage and commentary. There is a perception of outrage about the rescue plan being floated in Washington. I'll focus on the plan shortly, but I want to start by examining the perception. I am intrigued by some of the statements in the article. One person "lived within his means in an era of easy credit." Presumably, that is easier than living within one's means in an era of tight credit. Later the same person states he didn't buy an overly large house, and isn't behind on his payments. That's good. But to what extent is his success due to general growth in the economy? Did he benefit from the activity and decisions of others?

Another person in the article suggests this may take generations to unwind. That may or may not be true. I suspect it will affect how this and possibly the next generation make certain decisions - significant economic and financial events do that. But so do the rules and regulations that get put in place - that's why we have them. Still another person recalls a neighbor saying he didn't know how he afforded the house he bought, he "just signed." Evidently, those were the rules and incentives in place. The point is that none of the people interviewed seem to connect the situation we're in to the decisions and choices made by "us". Rather, there’s a tendency to recast the situation as created by "them." Some of us may have been concerned about housing and mortgages earlier in this decade, or even during the last. But we all benefitted because lower prices and financing for homes meant people could by more other stuff. "Us" was part of the "them."

Now, there is evidence that leads us to believe that the crisis may be restricted to a small (but very significant) segment of the financial industry. One of the terms bandied about recently is "credit crunch." But is there a credit crunch affecting Main Street? To me, that would imply a difficulty in finding credit. Yet, if we look at some data from the Federal Reserve Bank of St. Louis cited in the Marginal Revolution blog, credit continues to be available for consumer loans, commercial loans, and mortgages. So where's the problem? Blogger Alex Tabarok suggests it is in the area of short-term asset-backed securities. This would make sense as some of those investments were linked to mortgage loans of dubious origination. And if people doubt the value of the homes and the ability of borrowers to repay, everything resting on that foundation becomes shaky.

However, let's get back to the Post story. The subjects of the story are asking valid questions about their "role" in the bailout. This brings me to another concept. In economics, we often talk about externalities - benefits or costs that accrue to parties outside of a transaction. In the case of the proposed rescue, one could make a case that this is a case of huge negative externalities. Taxpayers are being asked to provide the funds to aid parties to transactions that did not directly involve them. Many of them did not purchase homes under questionable terms; and many did not purchase the derivative contracts that grew out of the housing boom. Consequently, the fall of housing prices and the ensuing collapse of the derivatives based on mortgages for those homes, sent ripples through the economy - negative externalities - costs that must be paid. But is the taxpayer the one who should pay for the externality? The question now becomes, was the taxpayer a beneficiary? One can argue that the average economic citizen benefited from a growing economy, stable financial environment and access to credit. To the extent that proposed plan maintains that condition, taxpayer involvement is appropriate. To the extent that taxpayers benefitted from “cheap and easy credit”, etc., it is also appropriate. Look at the past benefits, look at the present benefits, and consider the future costs.

This leads to a discussion about "them", or at least to one of the conveniently defined "thems". The rescue package is still being debated, so it is pointless address details. Nevertheless, one of the things the package will hopefully do (indeed I would submit it should be a major objective) is properly allocate costs, or as one of my econ teachers used to say "internalize the externalities." By that, he meant take the externalities and properly integrate them into the cost structure – who benefits and who pays?

To that end, a number of lessons are available to apply. As we see in this New York Times piece, (HT to blogger William Polley)Sweden underwent a mortgage-induced crisis in the early 1990s. The Swedish government intervened with a rescue package. But the Swedish government implemented some very strict conditions for intervention, among them: banks had to write down the losses before rescue. This means the losses had to be recognized on the books so that shareholder value was impacted first. Thus part of the externality was accounted for by the shareholders. Only then would the government intervene, taking stock warrants as collateral. This meant that if assets were later sold off above the price on the books, part of the profit went to repay the government. This is, if I understand correctly, part of what was done for AIG.

Now some are asking that banks be asked to do the same as AIG. But there is a subtle difference between what was done for AIG (and Freddie and Fannie) and what needs to be done for banks. This is because banks are...well, banks. The Federal Reserve System is already set up to deal with banks, providing liquidity through various channels, even taking debt as collateral. This is important. Generally when liquidating a firm, debt (liability) has a superior claim to assets over capital (owners), meaning the debt holders get paid first. While AIG was not a bank and therefore not in the normal procedures, banks can use existing channels to get money from the Fed. If the U.S. government or the Federal Reserve takes stock as collateral before a bank's losses are figured in; there is a risk of being last in line in case of liquidation. By taking debt, that should be less of a problem.

But there may be other ways of "internalizing the externalities". On the PBS program NewsHour on Tuesday, September 23, (HT to Greg Mankiw there was interview with a panel of economists about the proposed plan. All more or less agreed something needed to be done, but the consensus was that the plan needed modification. Of particular note were comments by Alan Meltzer of Carnegie-Mellon University. He suggested that the aid should be in the form of loans to be paid back with interest. (Indeed, if we look at some of the recent plans, loans not only are being made, but some of them have fairly steep interest rates – reflecting greater risk.) And that until the loans were paid back, dividends to stockholders would be suspended and bonuses to executives would also not be paid. (My initial reaction was "and don't let the executives jump ship until the loan is repaid." But I'm not sure having the same people steering the ship when it hit the iceberg is a good thing. Maybe you let them go without departure bonuses. To extend the analogy, this would be akin to setting them adrift in a lifeboat without the full complement of provisions.) Meltzer’s suggestion provides a certain incentive for the firms to mark down the losses, and then work quickly to restore profitability in order to pay off the loans. But that’s about "them", isn’t it?

We're still examining the "us" behind the rescue package. Even if the costs are properly shifted, there's still going to be some overhang. Who should pick that up? In the long-run, one could probably wait for a market solution, letting the losses hit various parties involved, whether culpable or not. That may not sit well with our sense of justice in some cases, and it may sit well in others. It depends on who is taking the specific hit. But one needs to look at the big picture. Fed Chairman Ben Bernanke, in his economic outlook delivered before Congress yesterday, pointed out that some things are being implemented that would reduce the potential loss to the taxpayer. The general situation is also causing reactions one would expect. "Nonconforming jumbo mortgages cannot be securitized and thus carry much higher interest rates" - so much for financing a big house on the cheap with little or no documentation. And he pointed out that the cases of Fannie and Freddie, while large and unusual, were largely the result of those organizations being government-sponsored, an issue that was addressed back in July.

Where does that leave us in the classroom? We've got lots of examples to use as explanations and illustrations when discussing externalities, incentives, the role of banks and credit, exotic financial instruments, and the role of the Fed (see last week's post). I also submit that, depending on the details of the rescue package, there is something to use when discussing institutions (the rules of the game) in the financial markets. Hopefully, the final package will not set up institutions that promote situations like this.

Overall, I am reminded of an anecdote an economist once shared with me after the savings & loan crisis of the late 1970s and early 80s. He was a guest on a radio call-in program and one irate caller said that “government got us into this; government should have to pay for it.” The economist then reminded everyone that we are the government. The "them" is "us". The same goes for the economy. The economy is merely the sum of all of our personal decisions. Our decisions are shaped, in part, by the rules we put in place (or allow to be put in place), and in part by our desire to improve our lot, our attempts to "get the most for the least." Whether we know that our actions are "right", whether rules are "correct", or whether the consumer/taxpayer ultimately gets the check, the economy is still of our making. We’re all on the same boat. That’s interdependence.

In the end, as the discussion on the bailout continues, and various constituencies jockey for their place at the payout window, I am reminded of something said by the French economist, Frederick Bastiat. To the best of my memory it was "we all look to live at the government’s expense, but we forget that the government lives at our expense." I look forward to your comments.

Wednesday, September 24, 2008

Opportunities for Teachers

The Powell Center for Economic Literacy is offering a number of programs that may be of interest to select groups of teachers.

First, for high school teachers, particularly those who teach A.P. Economics, the Powell Center and the Federal Reserve Bank of Richmond are sponsoring the biennial A.P. Economics Conference, November 2 - 4, 2008. The program offers sessions of particular interest to teachers of A.P. Economics, but may also be of interest to those of you teaching IB or other economics courses. This year's conference features speakers Tim Harford, author of The Logic of Life and The Undercover Economist; Russell Roberts, author of The Price of Everything and host of the EconTalk podcast site; and Federal Reserve Board Governor Kevin Warsh. For information on the program and registration, go to this page of the Powell Center site, and click on the links near the bottom of the page.

For middle school teachers in the Baltimore, MD area, Powell, in cooperation with the Baltimore Branch of the Federal Reserve Bank of Richmond and the Maryland Council on Economic Education is offering Mid-Size Economics, a program on economics for middle school social studies teachers in Maryland on Thursday, November 13, 2008. Teachers can examine the program and register at the Powell Center site.

The same groups will also be hosting a program on Kid-Size Economics for elementary school teachers, at the Baltimore Branch of the Federal Reserve Bank on Friday, November 14, 2008. Interested teachers can see the program and register here.

Please feel free to leave questions on this blog.

Friday, September 19, 2008

The Functions of the Federal Reserve

During the past couple of weeks, the financial turmoil has forced many people to focus on the Federal Reserve. While there are a number of good resources for teachers about the Fed, virtually all of them consolidated here, I thought it might be helpful to review some information about the Fed in a way that could help put its recent activity into context.

We are frequently reminded that the Federal Reserve is the "nation's central bank." And we will spend some time on that nearer the end of this post. But there are other functions of the Fed that are frequently overlooked, yet provide a background for what has happened as events have unfolded.

First, the Federal Reserve is a bank - or more precisely, a number of banks - and one of its functions is to act as such. But the Fed has an unusual clientele. Perhaps its most important customer is the U.S. government. The Fed is the government's bank. That means that all moneys sent to the U.S. government in the form of taxes, etc. end up deposited at the Fed. Likewise, Federal payments are drawn on the government's account at the Fed. The reason for this is that prior to the creation of the Federal Reserve, U.S. funds were deposited in private banks. This had the potential for favoritism and political patronage. As a consequence, placing federal monies in the Federal Reserve Banks eliminated that source of conflict.

The Fed also is a bank for banks. This also goes back to the formation of the Federal Reserve. One of the Fed's primary jobs in early years was to help limit bank runs. This was accomplished by charging the Fed with being the "lender of last resort." Essentially, banks could go to the Fed for money (cash specifically) if yhey did not have enough on hand to meet demand. The money would be borrowed against collateral (loans and government securities) and interest charged for the loan - the rate was called the discount rate. (Discount because the interest was paid off the front end of the loan - the loan was discounted by the amount of the interest.) It is this "lender of last resort" function that has played in some of the Fed's actions of the past couple of weeks. But you should be asking "how?" Many of the institutions involved weren't banks - therefore they weren't Fed customers. This brings us to the second function.

Another charge of the Federal Reserve is to maintain an efficient payment system. Usually this is done by providing currency and coin to financial institutions as needed; facilitating the clearing of checks drawn by one bank on another bank; and providing electronic payments and transfers between institutions. But in unusual circumstances, the Fed can provide funds in an effort to prevent the payments system from freezing up. Generally, banks can and do borrow funds from each to facilitate payment. But in times of stress, they may stop lending to one another - and they may stop lending to non-bank financial institutions (brokerages, investment firms, insurance firms). In situations like this, the Fed can step in - lending to banks to enable them to lend to other firms - to prevent the payment mechanism from coming
to a stop. And as we've seen, the Fed and Treasury have moved together to provide funds directly to non-bank financial firms to prevent the same thing. But like the "lender of last resort" idea, the Fed is taking securities as collateral - in some cases stock or stock warrants, in other cases loans.

The final role of the Federal Reserve is to act as the nation's central bank. This means it is responsible for making sure the nation's money supply grows at a rate that is conducive to price stability and maximum sustainable growth. Again, in times of crisis, the Fed may have to choose which of the dual mandates set forth by Congress take precedence. When the financial system is threatening to come to a halt - growth takes the front seat. Consequently, making more funds available (increasing the money supply) may generate concerns about inflation and the value of the dollar, but once the market stabilizes the funds can be drawn out of the system again. This is what happened during the stock market "crash" of 1987.

I've just provided a very general outline here. I would encourage you to check out the site mentioned earlier in this blog. (Here's the link, again.) And you may want to check the web site of your local Federal Reserve Bank to see if they provide additional information or resources.

I look forward to comments.

Thursday, September 18, 2008


For those of you trying to sort out what's behind the AIG implosion, the answer is a derivative contract called a collateralized Debt Swap (CDS). These contracts are used to transfer the risk of default on debt (bonds and other debt-based securities) to other parties. There's a good graphic explaining how they work here, courtesy of The New York Times.

The problem for AIG is their exposure to these instruments. As an insurer, they were involved in a lot of these contracts to help other firms hedge against loss. But the value of the underlying contracts (mortgages in many cases) was uncertain. This is leaving AIG exposed to a lot of claims as contracts go into default. When that happens, AIG makes a payment. Consequently, with the number of default payments they've had to make, AIG is short capital.

There's more to come on this, but in the interim, I will point you to two other resources that may help you as the smoke clears. The first is a YouTube video that features an interview with Princeton economics professor and former Federal Reserve vice-chairman, Alan Blinder. (HT to Greg Mankiw.)

The other is the blog by Professor William Polley at Western Illinois University. I met Dr. Polley when I was in Chicago and he writes one of the best Fed watching blogs for educators. I always appreciate his insights.

I look forward to your insights, as well.

Tuesday, September 16, 2008

Economics Comics

Comic strips can often be good resources for driving home a concept. They provide an interruption in the process, and create a mental "exclamation point" for reference. And they give us a chance to show the dismal science doesn't necessarily have to be that way all the time. Yesterday there were three useable comic strips that can be used in discussion of three quite different topics.

First, Dilbert's creator seems to be on one of his occasional side-trips to the imaginary country of Elbonia, which appears to be going through a period of hyperinflation. Change the name of the country to a certain African country that shall remain nameless, but rhymes with Grimbabwe and you may have a few resources to use when discussing inflation.

Second, the comic strip Curtis (courtesy of the Seattle Post-Intelligencer) gives us an interesting segue for discussing the prioritization of wants and status (as in Thorstein Veblen's conspicuous consumption), as well as something we can use in conjunction with yesterday's post on this blog about Who Pays?

Finally, the cartoon Non-Sequitur may have discovered what triggered the credit crisis - or what might be prolonging it.

Feel free to share your ideas.

Monday, September 15, 2008

Always Question the Data....

Just two more examples of why we want to make sure that students understand that correlation is not causation. (HT to Greg Mankiw.)

And if I may add...coincidence is not correlation.

Who Pays? An Economics Lesson at Home

This past weekend saw the first installment of what may prove to be an interesting and valuable resource for teachers of personal economics, as well as more traditional economics classes. The column, titled "Yoder and Son", was in the Sunday edition of The Wall Street Journal. Some of you may not have known there was a "Sunday edition." It's actually something that local newspapers can subscribe to and place in their Sunday Business sections. I find mine in the Richmond Times-Dispatch.

The article is co-authored by a Journal editor and his teenage son. And this approach provides a good platform for a balanced discussion. This first installment dealt with an interesting and, for some of us, familiar issue, "Who pays for things our teenagers need?" The specific situation was who would pay for a new set of guitar strings.

Both authors provided their arguments, and neither one of them really dealt with economics. But they offered the opportunity to infuse some economics. Suffice it to say, I sided with the dad, but not for the reasons he listed. My response was formed within about 10 seconds. But my reasoning took a bit longer.

When we talk about costs in economics and personal finance, we may begin to discuss fixed costs and those that are marginal. In this case, I saw dad's responsibility as covering the fixed costs - lessons, purchase of the original equipment, etc. The costs that were marginal, arising from the use of the good, I saw as his son's responsibility. My analogous example is a car. It's larger to be sure, but similar in my view. The parents may (students should notice here, I didn't say SHOULD)purchase a car for their students. They may even CHOOSE to cover insurance. These may be viewed as fixed costs related to owning the item. But I don't see it as out of line for students to be expected to cover gas, oil, and even routine maintenance. And if student action causes insurance costs to rise, I see that as a logical extension. These are marginal costs arising from the student's use. (Indeed, you may even convince me that any insurance is a marginal cost.) The guitar strings are similar. They are marginal costs arising from use, and unless dad's been sneaking the axe and doing "Stairway to Heaven," I don't see where it's his responsibility to keep the music flowing. The argument about restringing the piano is faulty if, indeed, it is a family instrument. I get the impression the guitar is strictly the son's instrument.

What are your thoughts?

Friday, September 12, 2008

On Productivity and Incentives

Earlier this week, The Wall Street Journal published a story about new software that is allowing the retailing chain, Ann Taylor, to measure productivity of their retail employees. The software (called ATLAS), was developed to see which workers were most productive in securing sales. The story goes on to say that Ann Taylor has then changed work schedules to put the most productive workers on the floor during the busiest shopping times.

On the surface, this seems like a sound strategy. When you've got the most traffic, you want the best sellers on the floor. But as author of the story reports, there's a downside. (Hmm, there's a trade-off to a decision - who would have seen that coming?)

The downside is that less productive workers are being relegated to shifts where there are likely to be fewer customers. This is impacting their paychecks. From the example cited, there are clearly fewer hours, but I presume there may also be an impact on sales bonuses or commissions. And as the article points out, once moved to a time with less traffic, it becomes more difficult to ring up sales. Again, this is easy to understand. However, in an interesting twist, one of the subjects of the article talked about her sales leads, developed over years of contact. The development of leads is clearly a time-intensive process, not always resulting in an immediate sale. And the idea of long-term vs. short-term gains in efficiency may play in here.

Overall, I think this is a good article to toss to your students to lead into a discussion about productivity and how it impacts various groups. Is there a responsibility to the stockholders to put the make the best resources available at peak times? What about for the customers? When more of them can visit, shouldn't they have the best service available? Does productivity provide an opportunity for workers? Do less productive workers gain an opportunity to hone their skills during less rushed times? Does this provide an incentive for them to improve their skills?

It also provides good background for a discussion on long-term vs. short-term incentives. Is the firm trading short-term gains in sales for long-term customer development by only putting the most productive workers (i.e. the most sales) on the floor during the busiest times? Does this mean the focus is the "ka-ching" or the relationship? What about customers? Will they begin to feel rushed as workers focus on the sale? And what about the workers - what happens if you're in the prime slot and you have a bad day?

I also find myself wondering what the alternative might be. I'm reminded of the BritCom, Are You Being Served? In that program, a customer would arrive, floorwalker (manager) Captain Peacock would then direct the prospect to the most senior sales person in the department first, and then on down the seniority line. One would hope there's a happy medium someplace, where the software can provide an opportunity for increased value for the firm, the employee and the customer.

Please share your thoughts.

Thursday, September 11, 2008

Making Payments

I suspect that this article from today's issue of The Wall Street Journal is not news to many of you. However, for those of you working with high school students (or college students) in either personal finance or a "traditional" economics course, this article is something you might want to hand out, even if it's just an "FYI".

Prepaid debit cards have been around for a while. But evidently the marketing is getting more aggressive. Parents and colleges have been complaining for a while about the way credit cards are marketed. (My position is that the bigger problem is that we don't spend enough time teaching students about credit. Credit is a tool. The problem usually lies in how it's used or misused. To borrow a quote I saw somewhere, "Lizzie Borden's axe was never on trial.")

Regardless, this instrument offers much of the convenience of credit cards. But it's a relatively expensive way to make transactions, and lacks some basic protections. As always in economics, it seems to be a case of "on the one hand, but on the other."

I think students and parents need to be informed about this payment option. What are your thoughts?

Virginia high school teachers may be interested in a Financial Education Summit sponsored by the Virginia Credit Union. The summit will take place on October 7 at Virginia Commonwealth University's Student Commons in Richmond. The program is free and interested teachers can find more information and register at the Virginia Credit Union website.

Wednesday, September 10, 2008

Markets, Complementary Goods, and Institutions

Discussion about how decisions are shaped by economic institutions (rules) is a repeating topic here. The idea is that rules (formal laws and informal beliefs) act to restrict our choices by imposing additional costs and/or providing additional benefits when faced with certain decisions. The costs can be monetary or physical (jail time); and benefits can range from subsidies to moral approbation (the “thumbs up" from peers). But, something we haven't dealt with very frequently (if at all) is the idea of complementary goods.

These are goods that see a corresponding rise or fall in consumption in conjunction with another good. Typical examples of complementary goods in economics classrooms are peanut butter and jelly, hamburgers and buns, or bagels and cream cheese. But another pairing that is frequently mentioned is automobiles and fuel. This brings us to the subject of today's post.

A recent issue of BusinessWeek has an article that is getting play in some corners of the blogosphere. The article deals with the Ford Fiesta Econetic, which is capable of 65 miles per hour, but won't be marketed here, in the U.S. Part of the reason it's not being sold here is that it runs on diesel fuel. The story is good fodder for discussion about markets (Why isn't it selling here? Demand questions.); complementary goods (Why would diesel fuel matter? Fuel taxes on and availability of diesel.); and institutions (What rules are relevant? Taxes again and public perception of diesel.). The article itself is kind of short, but you can get into more of the debate by checking out a blog entry by the author on "Can Diesel Ever Become Fashionable in the U.S.?" (I especially like the video in the second story -- sounds like Garrison Keillor singing.)

In my opinion, the downside to using this is that the question is open-ended, with insufficient information to bring discussion to a conclusion. I don't know how Ford reached the figure of 350,000 for the number units to be profitable, although I suspect it's a fairly straight-forward calculation of recovery of the cost to convert an engine plant. I suspect there may be a perception about the cost of diesel. I've not paid attention lately, but diesel was running at a 10 - 15% premium over gasoline around here, during the summer. However, if I had to pay even 20% more for the fuel and saw my mileage double, that may be attractive. But I would just need to know the price of the automobile to complete my cost/benefit analysis.

So you see, this little article is full of interesting twists and turns for you to use in an economics or even a personal finance class. (Of course, I don't know how these vehicles would run on diesel that contains 10% ethanol.)

I look forward to your comments.

Tuesday, September 9, 2008

Fundamentals of Banking

There are times when, while trying to do one thing, something else gets accomplished. This is akin to serendipity where you find one thing while looking for something else. In economics we would call it a positive externality - a benefit for parties outside the original transaction.

In the recent issue of The New Republic Robert Solow reviews Kevin Phillips' new book, Bad Money. It is serendipity for the economic educator.

I suspect that Solow's review was read by many people, looking to his suggestion about the book. But the rest of us benefit from an excellent explanation of the role of banking in the economy. Having read Solow's review, I'm not sure I would read Phillips' book, but for an introduction to the role of banks as intermediaries and transformers of risk, you'd be hard pressed to find something better than Solow's discussion. Furthermore, he gives good explanations of other issues like oil and the value of the dollar. For those of us looking for short, clear explanations of topics that our students often find confusing, consider this serendipity... or if you insist on using economic terms, consider it a positive externality.

I look forward to your comments.

Friday, September 5, 2008

Institutions Shape Markets

Lately, I find one of the more interesting aspects of economics to be the study of institutions (rules, beliefs and organizations) and how they shape the choices we make; and how this ends up being reflected in the marketplace.

The thinking is that the rules of the marketplace, whether they are formal nactments by governmental bodies, or informal beliefs adopted by individuals or cultures, help to define the choices we make. These choices ultimately help shape the marketplace, and may even generate an opportunity for an entrepreneur or group of entrepreneurs to add value where little or none existed before.

Today's issue of The Wall Street Journal offers just such a story. "Have Knife Will Travel" tells about farmers on Lopez Island in Washington who had a problem, saw an opportunity, and crafted a solution - and became a cutting edge (pardon the pun) idea in animal slaughtering and meat packing. And it offers a lot of opportunities to tie to your economics class.

The farmers on Lopez Island had to ship their animals 150 miles to the nearest
slaughterhouse that was USDA-approved, if they wanted to sell their product on the island. This took time, added cost, and (for those of us trying to be "green") added to the carbon footprint. "What to do?"

Several of the farmers recognized there was a burgeoning desire to eat locally-grown produce. "Why not duplicate that with meat?" Enter the first USDA-sanctioned mobile slaughterhouse. A truck makes the rounds on the island, and a professional butcher slaughters, and cuts and packages the meat. That meat is then delivered to grocers and other markets in the area. It's fresher and it has the panache of being "locally grown and produced".

The market for locally-grown food is growing. The desire for these products affects how people choose to buy food. (There's an example of an informal institution.) Examining the impact of this new institution, the entrepreneur (or in this case a group of them - the farmers) saw a new process - a new way of producing a good or service. This "new way" is, according to economist Joseph Schumpeter, what being an entrepreneur is all about. They got funding for their idea. They got the clearance from the USDA (the rules governing sale of slaughtered meat are another example of an institution - a formal one). And they set up the business.

The mobile slaughterhouse is also an example of adding value to the consumer. In this case, the consumer (of the slaughterhouse service) is the farmer. Consumers seek utility when they purchase a good or service. And some economists will talk about form, place and time utility. In this case, the mobile unit doesn't do anything unique in the way of form utility. But it does add time and place utility to the meat. Time utility is added by making the meat fresher when it hits the stores. Place utility is added by bringing the service to the farmer, as well as allowing them to advertise their product as locally grown and processed.

Can you think of other ways to use this story in your economics classes? I suspect there are even more ideas that just haven't crossed my mind yet. I look forward to your comments.

Thursday, September 4, 2008

Food Prices, Households, and "Core Inflation"

The most recent issue of the Chicago Fed Letter features an article on Food Inflation and the Consumption Patterns of U.S. Households by Leslie McGranahan. Leslie helped out in a number of economic education programs when I was at the Chicago Fed, and her insights were always helpful, whether it was as a Fed Challenge judge or a presenter at a teacher workshop.

Her article examines food prices increases over the past year, examines reasons for these increases, and relates them to food consumption patterns. Related to the last point, she finds that food price inflation has hit lower-income households harder than it has hit households in higher income brackets. McGranahan indicates that this is because lower-income households spend a larger percentage of their budget on food. What is purchased (in-home vs. out-of-home or restaurant) is also a consideration because low-income households spend a greater portion of their food budget on food prepared in home vs. food consumed in a restaurant. There is no surprise here although I recommend the article to teachers who of personal finance and economics who are looking for relevant and recent data for use in the classroom.

However, the article got me thinking along other lines. Currently, we hear and read a great deal about inflationary pressures. Depending on which measure you choose to use, consumer price index (CPI) or personal consumption expenditures (PCE), you get different numbers. But there is also a discrepancy between the overall numbers and the core inflation numbers. Core refers to the practice of "stripping out" food and energy prices. Critics of those measures state that it doesn't make sense not to count those prices because consumers have to buy food and energy. And they're right. If you're trying to measure the impact on the household, core inflation presents an incomplete picture - and incomplete in some very significant ways.

However, the purpose of the core numbers is to understand to what extent intermediate prices, such as wages, are creeping into other consumer prices. It is reasonable to assume that increased food and energy costs impact household budgets, and that this is reflected in increased wage demands, at some point. Those wages, as well as increased energy costs, can show up in the price of consumer goods and services in subsequent months. Essentially, by measuring the core, policy-makers can see to what extent those volatile sectors of food and energy costs are being passed through in a longer trend. This provides important information, without necessarily reflecting what's happening in households, especially those households at the lower end of the income distribution.

I welcome your thoughts.

Wednesday, September 3, 2008

Some History on Farm Subsidies

The St. Louis Fed has published a concise and interesting short essay on farm subsidies. It provides some basic history, as well as a good explanation of the economics. Additionally, it provides some links to articles and data sites.

For a teacher of economics or political science, trying to explain how the program came to be and how it works, this is good basic source that many high school students should be able to understand. And if it is above your student's reading level, the article is short enough that you can summarize it during class discussion.

I look forward to your comments.