Hahnel ABCs of Political Economy Modern Primer

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monetary policies that maximized the unemployment rate during Carter’s first term on election day – a remarkable display of political ineptitude – were not as simple or stupid as they appeared to many outraged liberals at the time.

The US trade account deficit jumped from just over $7 billion to just under $40 billion between 1975 and 1976, and then to almost $65 billion in 1977 putting serious downward pressure on the value of the dollar. What made this particularly worrisome was that Saudi Arabia was Washington’s ally inside OPEC and had prevented the OPEC oil price increases from being even greater by increasing its own production and sales. Since the oil price increases were widely believed to be responsible for a substantial part of the stagflation – rising unemployment and rising inflation – that rocked the European and US economies in the 1970s, Carter deemed it critical to persuade the Saudis not to abandon their opposition to the majority of their Arab brethren in OPEC who wanted to cut world supplies and boost oil prices even further. But the Saudis were asking why they should continue to trade oil for dollars if the value of the dollar was going to continue to fall – as it surely would if US trade deficits continued to rise. If the dollar was going to fall it was obviously better to leave more oil in the ground where it would only increase in value, rather than pump it out and sell it for dollars that were losing value. As a result, Jimmy Carter’s Secretary of the Treasury, Michael Blumenthal, was spending more time in Riyadh, the capital of Saudi Arabia, than in the capital of his own country, Washington DC, in an effort to assure the Saudi government that the Carter Administration was going to shore up the flagging greenback.

If Carter fulfilled his campaign pledge to aggressively combat unemployment this would increase production and income, but also US imports and thereby increase the trade deficit even more. Carter’s problem was that the only effective way to hold the line on the trade deficit, at least in the short run, was to cool down, not heat up the American economy. Carter adopted deflationary fiscal policies to slow the economy, and the trade deficit declined in 1979 to $45 billion and disappeared altogether in the election year recession of 1980 just as our simple open economy macro model predicts it should. Our simple model also sheds light on another “inexplicable” Carter Administration “betrayal” – the reappointment and encouragement of Paul Volker as chairman of the Federal Reserve Bank. While the trade account deficit would take two years and a recession to turn around, the Saudis required some more immediate

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and palpable show of good faith that the Administration was serious about shoring up the dollar. The only way to do that quickly was to raise US interest rates significantly above world levels to induce a massive inflow of finance capital on the short run capital account to counter the trade deficit until it could be reduced. Inflation fighter extraordinaire, Paul Volker was more than willing to do just that. So despite his election promise to prioritize the fight against unemployment over the fight against inflation, Carter reappointed Volker as chairman of the Fed, and Administration officials supported Volker’s tight monetary policies despite the fact that unemployment rose from 6% to 8% as election day neared, infuriating many Democrats in Congress who were also up for reelection.

My point is not that Carter chose wisely. With hindsight it is obvious he did not. Carter’s overwhelming loss to Ronald Reagan in the 1980 election ushered in the conservative Reagan era that has dominated US politics ever since, and Carter Administration fiscal and monetary policy bears a major responsibility for his election defeat. Instead, my point is that we need an open economy macro model to understand how international complications had more to do with Carter Administration economic policy than did political betrayal or economic stupidity.

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has, r, which is less than each deposited, D. If one withdraws on date 1 but the other does not, the one who withdraws gets D while the other one gets the remainder, 2r – D, which is not only less than D but less than r as well.

If neither depositor withdraws on date 1, the bank does not need to liquidate its loan asset before it reaches maturity and the bank is paid 2R > 2D on date 2 by its loan customer. If both depositors withdraw on date 2 each receives R. Or, if neither withdraws on date 2 the bank pays each depositor R. However, if one depositor withdraws on date 2 while the other does not, the one who does not withdraw is simply paid D and the one who does withdraw is paid the remainder, 2R – D, which is greater than R.

The payoff matrix for the two depositors on date 1 is:

The payoff matrix for the two depositors on date 2 is:

As in the Price of Power Game (chapter 3), we work backwards beginning with date 2. Both depositors will withdraw on date 2 if the game gets that far. If the other depositor withdraws I get R from withdrawing but only D if I do not. Since R > D I should withdraw if the other depositor withdraws. If the other depositor does not withdraw I get 2R – D by withdrawing but only R by not withdrawing. Since 2R – D > R I should withdraw if the other depositor does not withdraw. So no matter what the other depositor does, I should withdraw on date 2, and so should she. In other words, withdrawal is a “dominant strategy” for both players on date 2.

This allows us to fill in the missing payoffs in the south-east cell of the payoff matrix for date 1. If neither depositor withdraws on date 1 then the game goes to date 2. But now we know that if the

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game does go to date 2 both depositors will withdraw and each will receive R. So we can fill in R as the payoff to each depositor if both don’t withdraw on date 1, replacing (?, ?) with (R, R).

On date 1 if the other depositor withdraws I get r from withdrawing and 2r – D if I do not. Since r > 2r – D I should withdraw if the other depositor withdraws. If the other depositor does not withdraw I get D by withdrawing but (eventually) R by not withdrawing. Since R > D, on date 1 I should not withdraw if the other depositor does not withdraw. There is no dominant strategy equilibrium on date 1. Each depositor’s best move depends on what the other does. If I think the other depositor is going to withdraw, I should withdraw. Moreover, if that’s what happens – we both withdraw – neither one of us would have any regrets over our own choice, and therefore if we had it to do again we would both presumably withdraw again. On the other hand, if I thought the other depositor was not going to withdraw on date 1, I should not withdraw either. Moreover, if we both don’t withdraw, neither will have any regrets and wish to change our choice.3 So either mutual withdrawal or mutual nonwithdrawal are possible stable outcomes. But only one of these stable outcomes is efficient. Since (R, R) is better than (r, r) for both depositors, it is unambiguously more efficient. What we have discovered, unfortunately, is that this is only one of two equilibria. The other equilibrium outcome, mutual withdrawal on date 1, where each depositor withdraws for fear the other may withdraw, is inefficient and illustrates the logic of bank runs.

Notice that the model does not predict bank runs, any more than it predicts that depositors will always leave their deposits in banks until bank loans mature and all depositors get back more than they deposited in the first place. Instead, the model helps us see why both

3.What I have just explained means that both (withdraw, withdraw) and (don’t, don’t) are Nash equilibria (after the mathematician John Nash) for the date 1 game. They are both outcomes where neither party would regret their choice after the fact, so presumably if either outcome occurred, it would keep occurring – hence the word “equilibrium.” Neither of the other two possible outcomes is a Nash equilibrium: If I withdrew on date 1 and you did not, you would regret your choice and withdraw next time if you assumed I was going to continue to withdraw on date 1. On the other hand, I might regret my choice and not withdraw next time if I could be sure you weren’t going to change to withdraw because I’d just burned you. Similarly, if I don’t withdraw but you do we would each want to change our choice if we felt the other was not going to change theirs.

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outcomes are possible – the outcome where the bank promotes economic efficiency by helping both depositors do better than had they hidden their D < R under their mattresses, and the socially counterproductive outcome where bank failure leaves both depositors worse off than had they hidden their D > r under their mattresses. The model also makes clear the importance of depositor expectations about the behavior of other depositors in a banking system. If depositors trust other depositors not to make early withdrawals, all benefit (R > D, R > D). Whereas if depositors are suspicious that others may make early withdrawals, all lose (r < D, r < D). One way to think about deposit insurance and the minimum legal reserve requirement, is as a way to improve the likelihood that depositors will not panic, and therefore that the banking system will generate efficiency gains rather than losses.

INTERNATIONAL FINANCIAL CRISES

The same model can also be applied to international finance and help explain international financial crises and “contagion.” I chose the title Panic Rules! for a book4 about the global economy written right after the Asian Financial Crisis of 1997–98 because the “panic rules” described in chapter 7 were a useful way to begin to think about what had happened in those unfortunate Asian economies. You remember from chapter 7, there are two rules of behavior in any credit system: Rule #1 is the rule all participants want all other participants to follow: DON’T PANIC! Rule #2 is the rule all participants must be careful to follow themselves: PANIC FIRST! These “panic rules” succinctly summarize both the promise and the dangers of any credit system. If you substitute “international investors” for the word “depositors,” and “emerging market economy” for the word “bank” in the bank run model above, the model helps explain both the promise and danger inherent in today’s liberalized international financial system. Or, if you substitute “currency speculator” for “depositor,” and “emerging market currency” for “bank” you can learn much from the model about the potential benefits and dangers associated with making a currency “convertible” and eliminating all “controls” on who can buy and sell how much. As I explained in chapters 7 and 8, before even asking if a credit system distributes

4.Panic Rules! Everything You Need to Know About the Global Economy (South End Press, 1999).

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efficiency gains equitably between borrowers and lenders, we need to ask if the credit system, or innovation in an existing credit system, will actually yield efficiency gains rather than losses. The above model makes clear, there is always a possibility in any credit system that we could suffer efficiency losses (r < D, r < D), rather than enjoy efficiency gains (R > D, R > D), if participants obey Panic Rule #2 rather than #1. Those who speak of the benefits of financial deregulation, and new financial “instruments” invariably assume the positive alternative for their “product” and seldom warn us of the downside possibilities. It is true that if R is sufficiently greater than D, if r is not much less than D, and most importantly, if the probability of participants obeying rule #1 rather than #2 is sufficiently high, the expected value of the effects of the credit system will be positive. But the last “if” in particular cannot merely be assumed. It needs to be considered carefully. Insurance programs, reserve requirements, a lender of last resort, rules of disclosure, and a host of other factors all affect the probability that participants will obey one rule rather than the other – which our model makes clear is the allimportant issue. When these safeguards are absent or weak, as they are in today’s international credit system, and when “new financial product innovations” like derivatives magnify the downside risks, rational investors are more prone to obey Panic Rule #2 and the chances of efficiency losses are correspondingly greater.

INTERNATIONAL INVESTMENT IN A SIMPLE CORN MODEL

This model is a simple adaptation of the corn model from chapter 3. Instead of people we have countries. Instead of borrowing and lending between people we have an “international credit market” where countries lend to, and borrow from, one another. Instead of a labor market where people play the role of employer and the role of employee, direct foreign investment (DFI) allows northern countries to hire labor in southern countries to work using capital intensive technologies in northern-owned, multinational businesses located in southern economies.

There are 100 countries in the global economy, each with the same number of citizens. There is one produced good, corn, which all like to consume. Corn is produced from inputs of labor and seed corn. All countries are equally skilled and productive, and all have knowledge of the technologies that exist for producing corn. Each country needs to consume 1 unit of corn per year, after which they

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wish to maximize their leisure and only accumulate corn if they can do so without loss of leisure. There are two ways of producing corn, the “labor intensive technique” and the “capital intensive technique.”

Labor intensive technique, LIT:

6 units of labor + 0 units of seed corn yield 1 unit of corn

Capital intensive technique, CIT:

1 unit of labor + 1 unit of seed corn yield 2 units of corn

In either case it takes a year for the corn to be produced and seed corn is tied up for the entire year, disappearing by year’s end. Our measure of global inequality is the difference between the number of units of labor worked by the country that works the most, and number of units of labor worked by the country that works the least. Our measure of global efficiency is the average units of labor worked per unit of net corn produced in the world. There are 50 units of seed corn in the world; 10 northern countries each have 5 units of seed corn, and 90 southern countries have no seed corn at all.

I assume readers are familiar with how to analyze outcomes in the simple corn model from chapter 3 and compare outcomes under three international economic “regimes”: (1) Under autarky there is no international investment of any kind permitted. In other words, there is neither international financial investment nor direct foreign investment. (2) An international credit market allows countries to lend and borrow seed corn as they please. We generously assume that when we open an international credit market all mutually beneficial deals between lending and borrowing countries are discovered and signed, i.e. that the credit market functions perfectly without crises and efficiency losses of any kind.5 (3) Direct foreign investment (DFI) permits countries to hire labor from other countries to work in factories owned by the “foreign” country located inside the “host” country. By assuming the labor market inside host countries equilibrates we implicitly assume foreign and domestic

5.We drop this assumption below in the model that follows which substitutes a more realistic version of international finance for the “naïve” international credit market assumed here. The more realistic model allows for efficiency losses as well as efficiency gains from extending the international credit system.

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employers pay the same wage rate. If foreign multinationals paid higher wages than domestic employers our results would be slightly less unequal.

Under autarky each southern country will work 6 units of labor in the LIT while each northern country will work 1 unit of labor in the CIT. The degree of global inequality will be 6 – 1 or 5. The average number of days worked per unit of net corn produced, or efficiency of the global economy will be [90(6) + 10(1)]/[100] = 5.500

If we legalize an international credit market the interest rate, r, on international loans will be 5⁄6 unit of seed corn per year. Each southern country will work 6 units of labor either in the LIT or with borrowed seed corn in the CIT. Each northern country will lend 5C, collect (5⁄6)5 or 4.167C in interest, consume 1C and accumulate 3.167C without having to work at all. The degree of global inequality would increase from 5 to 6, although the degree of inequality would really be greater than 6 if we took into account corn accumulated by the northern countries. The efficiency of the global economy would increase since the average number of days worked per unit of net corn produced in the world would fall from 5.500 to [90(6) + 10(0)]/[100 + 10(3.167)] or 4.101. The intuition behind these results is that under autarky northern countries do not have any incentive to put all their seed corn to productive use. Each northern country uses only 1 of its 5 units of seed corn – the other 4 units are an idle productive resource. The international credit market gives northern countries an incentive to lend their seed corn to southern countries where the borrowed seed corn increases the productivity of southern labor. Because seed corn is scarce globally, the northern countries are able to capture the entire efficiency gain from the increased productivity in the southern countries.

If some technical change improved the efficiency of the LIT so it only required 4 units of labor to produce a unit of corn, the international rate of interest, r, would fall from 5⁄6 to 3⁄4 units of corn per year. Global efficiency would increase since the average number of days needed to produce a unit of net corn in the world would fall to [90(4) + 10(0)]/[100 + 10(2.75)] = 2.824 which is less than 4.101. The international rate of interest, r, decreases because the difference between the productivity of the CIT and LIT technologies is now less so southern countries are not willing to pay as much for the seed corn they need to use the CIT. Global efficiency increases because all production in the LIT is more productive, or efficient. Inequality decreases because lenders get less of the efficiency gain and

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borrowers more when r is lower. Notice that improving the productivity of more labor intensive technologies not only increases global efficiency, it ameliorates global inequality.

On the other hand, if some technical change improved the efficiency of the CIT so that it only required half a unit of labor together with 1 unit of seed corn to produce 2 units of corn, gross (or 1 unit of net corn), the international interest rate would rise from 5⁄6 to 11⁄12 unit of corn per year. Global efficiency would increase since the average number of days needed to produce a unit of net corn in the world would fall to [90(6) + 10(0)]/[100 + 10(3.583)] = 3.975 which is less than 4.101. The international rate of interest, r, increases because the difference between the productivity of the CIT and LIT technologies is now greater so southern countries are willing to pay more to get access to the seed corn they need to use the CIT. Global efficiency increases because all production in the CIT is more productive, or efficient. Inequality increases because lenders get less of the efficiency gain and borrowers more when r is higher. Notice that improving the productivity of more capital intensive technologies increases global efficiency but aggravates global inequality.

If instead of an international credit market, we legalize direct foreign investment, the wage rate in southern economies will be w = 1⁄6. Each southern country will have to work 6 units of labor, whether in the LIT in domestic owned businesses or in the CIT in northern owned businesses located in the southern, or “host” country or some combination of the two. Each northern country will hire 5 units of southern labor to work in the northern country’s businesses located in southern countries, producing 10C gross, 5C net, paying (1⁄6)(5) = 0.833C in wages, and receiving 4.167C profits. So each northern country will consume 1C and accumulate 3.167C without working at all. The degree of global inequality would increase from 5 to 6, although inequality would now really be greater than 6 if we took into account corn accumulated by the northern countries. The efficiency of the global economy would increase since the average number of days worked per unit of net corn produced in the world would fall from 5.500 to [90(6) + 10(0)]/[100 + 10(3.167)] = 4.101. Again, the intuition behind these results is that direct foreign investment gives northern countries an incentive to use seed corn that was idle under autarky to employ southern labor that was previously working in the LIT under autarky, in northern businesses located in the south using the CIT – thereby raising the productivity of some southern labor. Because seed corn is scarce globally, the