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    Debt Compromises

    Jul 23 • Developing Economies, Economic Debates, Economic History, Economic Thinkers, Financial Markets, Government, Macroeconomic Measurement, Money and Monetary Policy • 625 Views

    This story is about a country that had massive debt. A recent war had been expensive and the economy had big problems. Still though, powerful political leaders opposed the solution that the Secretary of the Treasury proposed.

    Yes, the country is the United States but the year is 1790. Because of the Revolutionary War, the U.S. owed French and Dutch bankers $11,710,378. From citizens at home it had borrowed $42,414,085. Using calculations from historian John Steele Gordon, the U.S. Revolutionary War debt was close to $19 trillion in today’s dollars–$5 trillion more than we currently owe. Behind on interest payments, a worthless currency (“not worth a continental”), a huge national debt, rampant inflation, we faced debilitating obligations. What to do?

    To manage the debt, Alexander Hamilton first had to solve 2 problems.

    Problem 1: Who legally owns U.S. bonds?

    Revolutionary war bonds were primarily held by wealthy merchants and unscrupulous speculators who had purchased the securities when they were virtually worthless from loyal patriots. Enraged, James Madison said that the present bondholders should get a partial repayment and the original holders should get the balance. Opposed also, John Adams was said not to understand the connection between funding a national debt and economic prosperity.

    By contrast, Hamilton realized that for the economy to grow from a sound foundation, contractual obligations had to be preserved. When a bond was sold, the new owner, whether a widow or a shady speculator, had to be recognized in the eyes of the law. 

    The final vote in the House, supporting the Hamiltonian plan, was 36-13. Hamilton’s father-in-law, who owned government securities, said that the opposition’s comments “made his hair stand ‘on end as if the Indians had fired at him.'”

    Problem 2: Should the federal government assume the states’ war debts?

    Some states like Virginia had repaid their debts while others, including Massachusetts, had not. On this issue, Jefferson was Hamilton’s main adversary. Hamilton said the U.S. was responsible for all existing debts; Jefferson said Virginia should not have to pay “twice.”

    To secure a compromise, Hamilton invited Jefferson to dinner. Accompanied by Madison, Jefferson agreed to support the assumption plan if the new capital would move from New York to the “muddy and fever-ridden banks of the Potomac.” (p. 31)

    So, you can see that our Congress has always been divided on debt issues. And, when it really mattered, they voted, they compromised and they made a wise decision.

    Here, in American Heritarge Magazine, you can read more about Hamilton’s proposals, the opposition, and the resolution through which European and domestic bondholders were repaid. In Hamilton’s Blessing, historian John Steele Gordon provides a more detailed history of the U.S. debt through 1995.

    The Economic Lesson

    With good credit, for relatively low interest rates, a nation can borrow money from creditors at home and abroad. According to scholars Kenneth Rogoff and Carmen Reinhart, the tipping point at which debt becomes excessive and unmanageable for most nations appears to be 90% of GDP. In 2010, the U.S. debt was close to 90% of its GDP.

    An Economic Question: Referring to funding and how it is used, explain how sovereign debt relates to economic growth.

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    Vaccine Dilemmas

    Jul 22 • Businesses, Demand, Supply, and Markets, Economic Debates, Government, Households, Macroeconomic Measurement, Thinking Economically • 593 Views

    Let’s try to make one federal budget decision. Who should receive the meningococcal vaccine?

    Debating the issue, we should be sure to remember pharmaceutical companies, the vaccine’s recipients, the cost of each shot, who gets the disease, the federal budget.

    Pharmaceutical companies need profits. Then they have more money for R&D for new drugs that can save lives, they can pay dividends to elderly shareholders who need the money and to younger families for their college savings. The research for the vaccine might have been very expensive. So, they might decide to charge $189 per dose.

    Through programs such as Medicaid and Medicare, government pays for vaccinations. Stockholder owned insurance companies also pay for vaccinations. With millions of people getting the vaccine, it could cost $1 billion. Consequently, people might say the $189 for the meningococcal vaccine is too expensive.

    Statisticians tell us that several thousand people get the disease annually. However, a headline about a meningitis outbreak generates considerable fear.

    Finally, the national debt is soaring. More spent in one area means less elsewhere. Or it could eventually mean bond defaults that would place the U.S. financial system in disarray.

    So, how to decide?

    In the Department of Health and Human Services, at the US Centers for Disease Control and Prevention, the ACIP (Advisory Committee on Immunization Practices) decides. Typically, whatever they recommend, the government and private insurers pay for.

    In 2005, the ACIP placed the meningococcal vaccine on their recommended list for adolescents. They knew, though, that the cost was $189 a shot, and the yearly government expense, $387 million. The benefit? Preventing 23 deaths and illness for several thousand. Then, during 2010, when they concluded a booster shot, doubling cost, would also be needed for most recipients, they decided again to recommend it. They said it was a tough decision.

    Looking at the ACIP website, you will see all of the vaccines they recommend for every age group.

    The Economic Lesson

    A positive externality is the benefit enjoyed by a third party who has not participated in a contract or agreement between others. It could be called a spillover.

    Vaccines create positive externalities because their recipients do not spread the disease against which they have immunized.

    An Economic Question: If you were a member of the ACIP, explain why you would have been for or against recommending the meningococcal vaccine.

     

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    Chinese Basketball and Adam Smith

    Jul 21 • Behavioral Economics, Developing Economies, Economic Thinkers, Labor • 643 Views

    It is called the “womb to tomb model.” Selected as young children because of their exceptional height, future Chinese basketball players are educated separately. Whereas traditional Chinese schools have few, if any, extracurricular activities, their sports schools focus on athletics. Run by a government commission with programs that echo the former Soviet Union’s 5-year plans, their goal is world-class teams.

    It has not worked out that way. Yes, Yao Ming, the #1 draft pick of the Houston Rockets in 2002, is Chinese. However now, the China State General Sports Administration is looking for lots of Yao Mings. And that is the problem. Not only has the Chinese government been unable to predict who will be a great player but also, they have not figured out how to create viable teams.  Explained by the NY Times, the Chinese authorities did not realize that they also needed smaller faster talent, and, even if they had known, the system precludes them from selecting the right people and optimally developing their skills.

    By contrast, U.S. basketball has been described as Darwinian. It is a recreational activity, it is a school sport, it is a profession. Self-selected, coach-selected, team-selected, informal and professional, no government tells people who should and should not play. Maybe like Adam Smith?

    This Wharton Knowledge article describes the history of Chinese basketball and its contemporary relationships with the NBA and Nike.

    The Economic Lesson

    Seemingly chaotic because government does not exert central control, there is an underlying order within a market system that was described by Adam Smith. Although consumers and producers are motivated by their own self-interested incentives, people’s wants and needs are satisfied. In a similar way, perhaps, the U.S. basketball system successfully develops talent.

    An Economic Question: Might we credit the success of basketball in the U.S. to a system that resembles the apparent haphazard character of the market but actually has its own inherent order? Explain.

     

     

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    Venezuela’s Economic Problems

    Jul 20 • Businesses, Demand, Supply, and Markets, Developing Economies, Economic History, International Trade and Finance, Macroeconomic Measurement, Regulation, Thinking Economically • 1282 Views

    Venezuela has 2 basic economic problems:

    1. The law of supply: Because price and quantity move in the same direction, if price goes down, then producers provide less. This takes us to Venezuela’s 27.1% inflation rate. President Hugo Chavez responded by controlling the prices of many consumer goods and services. One result? Importers pay the soaring world price for corn, they receive the Venezuelan government’s controlled price for corn oil, and supermarkets have shortages.
    2. The law of demand: Because price and quantity have an inverse relationship, consumers want to buy more when price goes down. Here, Marketwatch tells us that government subsidized gas prices are so low in Venezuela that President Chavez chastised Venezuelans for excessive driving. At $.12 a gallon, it costs $2.40 to fill a 20-gallon tank! Complementary products? Venezuela had unusually high Hummer sales.

    So, when, Transparency.org says that Venezuela ranks near the bottom on world corruption scores and the Index of Economic Freedom indicates business activity is limited by multiple government constraints, the results can be explained by supply and demand.

    The Economic Lesson

    This takes us to the three basic economic questions that every country needs to answer:

    1. What will be produced?
    2. How will goods and services be produced?
    3. Who will receive income?

    When government distorts supply and demand decisions by controlling prices, it changes the answers to the 3 economic questions.

    An Economic Question: How could price controls change the answers to the 3 economic questions?

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    Mixed Euro Zone Metaphors

    Jul 19 • Economic Debates, Economic History, Financial Markets, International Trade and Finance, Thinking Economically • 606 Views

    In this Economist podcast, journalists describe the euro zone debt crisis with a wonderful array of metaphors. (Directly and indirectly, I quote what they said.)

    • Minnows: The smaller peripheral nations in the euro zone, Greece, Ireland and Portugal are minnows.
    • The Big Fish: With the third largest economy in the euro zone, Italy is a big fish.
    • An Infected Core: The debt “illness” that has struck the euro zone has moved from the minnows on the periphery to a big fish at the core. Described as “too big to save; too big to let fail,” Italy has been a “stealth debtor” with sovereign debt close to 120% of its GDP.  Still though, like a family that has managed massive credit card debt for many years, Italy has successfully handled its obligations. However, if the Italian bond market has been “infected,” then the cost of borrowing could soar. The result? Italy will lose control of her fiscal responsibilities.
    • A Badly Dented Can: Thus far, euro zone leaders. coping with the tension between “political and economic imperatives,” have opted for short-term solutions. By “kicking the can down the road” they have badly dented it. Now, before it breaks, as the contagion spreads, they need a long-term resolution.
    • Fewer Days at the Beach: As a result, euro zone leaders will need to spend considerable time this summer developing a solution.

    The Economic Lesson

    Monetary policy involves the supply of money and credit. Fiscal policy takes us to spending, taxing, and borrowing. The euro zone oversees the monetary policy of its 17 member nations but not their fiscal policy. And therein lies the problem. Monetary policy and fiscal policy are closely related. Banks buy sovereign debt.

    An Economic Question: How are U.S. fiscal and monetary policy in the U.S. related and yet also separate?

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