Wednesday, April 30, 2008

Higher Prices: It's Not Just the Money

For people who fly regularly, this summer is not shaping up to be a pleasant experience. Airline travel is becoming more expensive (subscription required). Part of this is due rising fuel costs (subscription required). Other contributing factors include an worsening shortage of trained pilots (subscription required). Both of these mean rising costs that are passed on to consumers. Some airlines are even charging extra (subscription required) for a second bag.

But this environment also offers a great lesson for those of us who teach economics and personal finance. The lesson is a fundamental one that sometimes gets left out due to lack of time. That lesson is analyzing cost.

Now some of readers are saying "I have the students do comparative pricing," and others are ready to respond with "My students can graph fixed and marginal cost vs. revenue". But that's not the whole story. There are non-financial costs that figure into or should figure into our students' decision-making. While we may agree that it is important, we're sometimes at a loss of how to proceed.

Higher costs are causing airlines to cut flights and fill every seat (FREE content). And mergers usually have a way of translating into fewer flights (FREE content). This means that more of your time may be spent getting through security lines, checking bags (for that extra fee), and waiting for connections. But what is time worth? Some students may respond with "I'm on vacation, so it doesn't matter." But any of us who have been stuck in a terminal know that's not true. As with our finances, so it is with our time. There's something called opportunity cost. Instead of sitting in a terminal, waiting for the airplane, you could have been spending more time at home, at your vacation site, or just about anywhere else.

What's your time worth? The simplest way to measure this is to ask "what's your wage?" Your wage is a market approximation of the value of your time. You may say you're underpaid. Heck, your boss may even agree with you. But the fact is your wage is the economic value of your time as it applies to at least one activity.

Another way (although less specific) is to look at emotional and other costs. How does whiling away time in the terminal make you feel? Angry? Anxious? Bored? Those are all valid reactions and affect your emotional satisfaction received from the trip. If it's negative, it reduces the satisfaction. And if it increases your blood pressure...

The point is that choosing to fly encompasses more than a financial decision. This is increasingly so in the current environment. And students should understand that all these factors are valid ones in considering whether to fly...or to look for available substitutes such as trains, autos, or just putting that trip off to another time.

I welcome your comments.

Tuesday, April 29, 2008

Monetary Policy: Lessons from the Past?

One thing about trying economic times, they make a great time for learning as well as teaching. Because of the triple convergence of credit market disruption, rising prices and falling dollar value, this is a great time to review what we know and what we teach about monetary policy and central banking.

One of the early theorists of central banking was Walter Bagehot. He is perhaps as well-known for being one of the early editors of The Economist magazine, he also wrote a classic work of central banking, Lombard Street: A Description of the Money Market. Written when London was the financial capital of the world and gold was the monetary standard, Bagehot managed to write about the role of banks and central banks during times of domestic and international financial crises in terms that have relevance today. This brings us to two articles.

The first article appeared in last Friday's (April 25) issue of The Wall Street Journal. The author, Ronald McKinnon of Stanford University, points toward the works of Bagehot in recommending action to the Federal Reserve. Specifically, he references Bagehot's advice to "lend freely at high rates of interest." The lending is designed to let investors know that money is available. The rate is to reassure investors - particularly foreign investors - that the nation remains a sound place to invest. To this action, McKinnon notes that while the Fed has lent freely (opening lending channels and lending to investment banks), the "high rates of interest" portion of the prescription has been lacking. As a result, the dollar has suffered in foreign markets, and some international capital has withdrawn to pursue other opportunities. In defense of the Fed, there has also been concern about recession, and the lower rates were meant to stimulate the economy at a time when the greatest perceived risk was of a slowdown.

But this brings us to the second article. In today's (April 29) issue of The Wall Street Journal, John L. Chapman of the American Enterprise Institute, says The Fed Must Strengthen the Dollar. Chapman does not allude to Bagehot, but his reasoning is similar. A return to a more vigorous dollar would do much to bring price pressures under control and restore credibility to U.S. financial markets.

Chapman does point to the Phillips Curve as a possible source of problems for policy makers. He believes that there is a misplaced reliance on the curve's trade-off between inflation and unemployment. And while that may be a factor at the central bank, I would hasten to add that the Fed does have a dual mandate to consider. And that mandate of price stability with maximum sustainable growth (and full employment) could provide some incentive to consider the trade-off, even if it has not held up under extreme conditions.

So what does this mean as we teach? In general, we need to be sure our students understand that monetary policy is far from an exact science. They need to understand that when economic policy is focused on one goal, other goals may be negatively impacted (i.e. focus on recession and you may sacrifice price stability and/or foreign exchange). Finally, we are remiss if we don't point out that while the Fed is designed to be "insulated" from political pressure, insulated is not the same as isolated. And since the Fed has a dual mandate, unlike many other central banks around the world that have single mandates of price stability, it has a more complex job - not unlike "walking a tightrope in a windstorm." Schools still involved in The Fed Challenge may want to take note.

I look forward to your comments.

Monday, April 28, 2008

For More Food, Lower the Barriers

I'm three days late on this one, but it was a hectic weekend and I didn't have time to catch up on my daily reading until late on Monday. That's my story and I'm sticking to it.

In Friday's (4/25/08) issue of The Wall Street Journal, there was an interesting opinion piece about the hot button issue, Food and Free Trade. The authors, Nancy Birdsall of the Center for Global Development in Washington, D.C. and Arvind Subramanian of both the Center for Global Development and the Peterson Institute for International Economics, discuss the current food problem, and identify three major factors as contributing factors: rapidly growing Asian demand for food, biofuels, and drought.

While they point at some short-term actions that can be addressed at the next G8 summit in June, they also point at two trade policies that are aggravating the crisis. And reversing these policies, while having little probable effect in the short term, could go a long-way toward solving what appears to have the potential of a long-term problem.

Birdsall and Subramanian point to biofuel policies that essentially remove food supplies from the world market in the name of energy self-sufficiency, and export restrictions on food stuffs. They see this last item as more important than the removal of import barriers (and I'm presuming other subsidies) as are being discussed in the current Doha Round of trade negotiations. I may be incorrect in my presumption, but the authors do feel that import restrictions are currently being dropped voluntarily as each country tries to ease inflows of food. However, I don't see it as impossible that the barriers would be reimposed at the first sign of easing price pressures. And while current high prices probably make subsidies for some foods unnecessary, the complex maze of import barriers / export barriers / production subisidies has, in my opinion, so obscured the price signaling mechanism, that it is hard for any food producer anywhere to get an accurate read on the real market price. Consequently, the incentive structure cannot clearly point to the solution to this problem. And, this obscuring of the message only encourages speculation.

In the interim, some people riot, some people discuss, and others go hungry. Do we chalk this up to the Law of Unintended Consequences and try to "engineer" a new solution, with a new policy, and new unforeseen effects? Or maybe we can learn some basic economics?

I look forward to your comments.

Not as much an update as it is an interesting story for use in the classroom, particularly if you and your students are unfamiliar with the producer side of this story. Check out the story on All Things Considered on NPR.

Thursday, April 24, 2008

Do Systems Make a Difference?

While a discussion like this usually takes place when discussing economic systems, it can also fit in at the end of the semester when you discuss international economics and globalization. When the issue of economic development arises, one must address the system and how it affects development.

In that light, I have two articles to recommend. The first article was on Cafe Hayek a couple days ago, posted by Don Boudreaux. It was his counter to Earth Day and discussed the many plusses we have because of the capitalist system. One can certainly debate whether many of things would have come about anyway, but I think one can make the argument that they wouldn't have arrived as quickly, or spread so far or evolved to the present level without the spur of market competition. But your students may feel that this is fine for the "big things"; but ask how capitalism has changed some of the more "important" aspects of their lives.

I point you now to yesterday's post on Carpe Diem by Mark Perry. Scroll a ways down and you'll see a table comparing features on automobiles in 1985 vs. 2007. Specifically, what features were deemed "essential" and by what percentage of buyers. Much of the difference was generated demand - someone saw it and said "me too." But much was also generated by producers seeking to differentiate themselves in a competitive market or market niche. Provide a bit more for the customer to make your product stand out from the competition. And as more was produced, the technology allowed the marginal price to fall - making what was "optional" become a "standard."

It reminds me of something I read about the genius of the capitalist system not being that it provided silk stockings for the queen, but that it put those stockings in the reach of the working girl who made them.

I look forward to your comments.

The economist who made the comment about stockings for the queen (Queen Elizabeth to be exact) was Joseph Schumpeter. I actually suspected it was Schumpeter, but I was having trouble tracking down the quote.

Monday, April 21, 2008

Basic Saving

When teaching personal finance, we always stress the importance of saving and the different ways to get there. An article in today's issue of The Wall Street Journal titled "Savings Strategies" (now subscriber content) provides six real life examples of how people have built their savings, sometimes after significant life events.

I strongly recommend you take a look at the article and consider whether your students could benefit from these real-life stories.

Digging Deeper on NAFTA

One of the things I often told my students way back when was to try to read articles with one question in their mind: "What isn't it telling me?" I ran across an excellent opinion piece in today's issue of The Wall Street Journal that can provide a good example of why this is a good habit to form, but also provides an opportunity to practice the skill.

In a piece titled "What Nafta Trade Deficit?" John Engler, President of the National Association of Manufacturers and former governor of Michigan talks criticizes political candidates and other anti-NAFTA pundits for not telling the whole story about the effect the treaty has had on our current trade situation. A number of people have been talking about how NAFTA has hurt the U.S. trade balance. The "new information" Engler brings to the debate is how much of the NAFTA deficit likely would not have been side-stepped regardless of whether or not we had a free trade agreement in place. Specifically, he points at energy imports (oil and natural gas from Mexico and Canada) as contributing the vast majority of the current deficit - $58 billion of the $62 billion according to him.

This raises two questions for purposes of this post.
1) What benefit is there to anti-trade critics to avoid this aspect of our trade?
2) What is the source of the author's data?

For the first question, if the representation is accurate, this puts a different spin on how NAFTA affects the nation, especially if we are to believe that it is manufacturing that is the loser, rather than our inelastic demand for fossil fuels. A follow-up to that might be what could be the impact on energy prices without the agreement? (I don't know but I will ask.)

For the second question, for me to believe that the author's spin is not equally suspect to the spin of trade critics, I would like to know the source of the data. That way, if I wanted, I could go to the source and see for myself, even if it meant playing with the data. And as a follow up to that, I would like to see the source for his assertions about the impact of NAFTA on manufacturing. For me, it helps his credibility that he represents a manufacturing group and is not claiming undue harm. It would be all too simple to state that trade hurts his membership. But it would be a potentially stronger case if I knew the source of the information.

What do you think? Is critical thinking like this an aspect that we should be teaching the students? What's the opportunity cost of helping them examine information in this way? And what's the opportunity cost if we don't?

I look forward to your comments.

Thursday, April 17, 2008

Does Money Buy Happiness?

It's often said that money doesn't buy happiness. This saying appeals to our concerns about the "crass materialism" of modern society. And it is sometimes used as an argument against measuring progress in strict economic terms like "per capita gross domestic product". There's even something in economics called "the Easterlin paradox" that is often cited to back it up. This paradox cites that, measured at a national level, happiness does not seem to rise once certain basic needs are met. In other words, "more is not necessarily better."

On a personal level, I don't think money necessarily equates to happiness. One also has to consider issues of personal values and self-satisfaction - psychic income if you will. But is it true on a national scale?

A recent article in The New York Times (HT to Greg Mankiw) points to some new research that, if it doesn't disprove the Easterlin paradox, at least raises new questions. The article looks at a paper by a couple of economists at the University of Pennsylvania that raises some interesting issues. Their study seems to show a possible link between economic well-being and happiness. But the paper also raises questions in my mind: how do you measure happiness? On a national scale? How time sensitive is the survey? (This last is important because questions of self-satisfaction and well-being can often be answered in widely different ways, depending upon mood and recent experience.) I will need to read the paper to answer the questions. Nevertheless, the graphic in the NY Times article seems to offer some basis for discussion. At the same time, we need to be aware of an issue raised here before: coincidence, correlation or causation?

We often talk to our students about the importance and value of economic development. Does the Easterlin paradox mean we should only worry about improving people's lot up to certain point? Or is there value in promoting economic development across the board? I think this article has "interesting classroom discussion" written all over it. What do you think and what do your students think?

Wednesday, April 16, 2008


One of the more interesting aspects of macroeconomics is making connections for students between things that may seem unconnected. A prime example that is also a sometimes thorn in the side is the connections between government budget deficits, the current account (trade) deficit, and savings.

The former President of the Federal Reserve Bank of Dallas, Bob McTeer, has an excellent explanation and a helpful graphic to help with the explanation. I particularly like the way he starts with a simple, closed economy with no government to build the model, and then expands to include trade and government.

What do you think?

Tuesday, April 15, 2008

Commodity Prices: Malthus, Policy, or Development?

A front-page article in yesterday's edition of The Wall Street Journal (WSJ) headlined the problem of world food prices (now subscriber content). It was a main topic of discussion at last weekend's meetings of the International Monetary Fund (IMF) and World Bank in Washington, D.C. Rapidly rising food prices are making it hard for the world's poor to feed themselves. And policy-makers are facing tough choices.

So how do you use this in your classroom? It is current. Whether you get your news on-line, through radio or TV, or even via newspapers or news magazines, it's the topic-du-jour. It's personal. I suspect all of your students have heard parents or other care-givers talk about food prices. And teenagers may have noticed rising prices on food they buy. What are some good ways to integrate the topic into your economics or personal finance classes?

There are a number of angles you can use here. And they are based on three of the main arguments that are surfacing again and again in news stories.

One is to use the work of Thomas Malthus to introduce the discussion. I blogged on this back on March 24, and referenced another WSJ article. Malthus talked about population outstripping resources, and this is an idea that students often latch onto, because it is an easy explanation to understand. But while Malthus's observations were valid, given the relatively steady state of the world economy up to the Industrial Revolution; his conclusions failed to take into consideration the effect of changing technology and the ability of new forms of capital to increase productivity and raise real incomes without causing massive starvation. Yet, every time concerns about resources arise, people dredge up the specter of Malthus, and once the concerns dissipate, the specter recedes. If you use this approach, you can help students understand that, while simple, appeals to Malthus really only apply to a steady state that does not adequately reflect economic reality.

A second approach is to examine economic policy. As is pointed out in the article from yesterday's WSJ, a number of nations are blaming the U.S. decision to promote corn ethanol as a bio-fuel source as a reason for rising prices first in the corn and other commodity markets. The thinking goes that by subsidizing corn production and diverting the resulting crop to fuel, there are two effects. First, increased corn production often means reduced production of other crops. Reduced supply of these other crops helps push those prices higher. Diverting a portion of corn crop to fuel production (where the highest price is offered), takes the corn out of the food chain. This again can shift the supply curve left and can result in higher prices. (It is interesting to note in the article that some nations are leveling the charge at the U.S. while pursuing similar prices in their own markets - kind of a "stones in glass houses" thing.) And other nations are implementing policies to impose export taxes on grain in an effort to keep supplies available for domestic use. However, the result is that world prices are driven higher as demand has to be met by other supplies. This approach can provide opportunities to discuss aspects of government policy and responsibility, globalization and interdependence, and market distortions and market forces. Gary Becker and Richard Posner have an excellent discussion along these lines on their blog.

This brings us to the final approach, which is economic development. You can pick up pieces of this approach in virtually all the links I've cited. The argument is that as economic development has taken place in a large number of countries, incomes have risen. With these higher incomes has come increased demand for a variety of products based on basic commodities. People in developing economies have improved their diets, as well as the consumption of other products, including energy in various forms. This is normal and to be expected. (Who among us does not change consumption patterns with improved income?) But this also places increased demand pressures on a wide variety of goods. And as demand shifts to the right, prices rise. And when faced with rising prices across of swath of consumer products, we generally prefer that price be brought into line rather than face choices about what products to cut back on. This is a basic idea, both in economics and personal cinance. And while the choices are unpleasant, they are no less real. This approach to the topic has the advantage of making opportunity cost personal, as the students need to discuss real choices they face.

The truth probably contains a bit of all three (yes, even a little touch of Malthus) and the topic has much more to offer than I've outlined here. But these ideas should offer some starting points. If you see additional possibilities for these articles and the information, please share them here. I'm sure others would appreciate your thoughts, as I do.

Monday, April 14, 2008

Rethinking an Economic Unit

Much of the economic data we collect is collected on the national level. But an opinion piece in the Weekend Edition of The Wall street Journal has me wondering about alternative sources of data.

In his piece, The Rise of the Mega-Region, Richard Florida talks about how certain regions (combinations of cities, suburbs and surrounding areas) host business and economic activities "on a massive scale". He checks off some impressive statistics. Compared to 191 countries in the world, there are 40 mega-regions. These regions are "home to more than one-fifth of the world's population," and they "account for two-thirds of global economic output and more than 85% of all global innovation" according to Florida.

The idea that the city is the important unit for economic growth and development is not new. I first ran across the idea in two books by Jane Jacobs. Her 1969 book, The Economy of Cities, and her 1984 book, Cities and the Wealth of Nations, both spoke to the point. And while I have not read Mr. Florida's book, Who's Your City? and really can't say much about it; based on the reviews I've read, I suspect it contains similar ideas.

Anyway, Mr. Florida's article was interesting in that it addressed how we make policy - often basing it on nations instead of, as he suggests, being concerned about regions. Where it started me thinking was the connection between policy and data.

I would think effective policy-making would depend, at least in part, on accurate data. And I suspect collecting data on some of these regions would be a daunting task. Many of them cross political boundaries. But the more basic questions is this, "How far" does the region extend?" If one were to begin targetting these mega-regions for any special treatment, wouldn't one be creating incentives for those areas on the margin? Wouldn't they be seeking to be included/excluded depending on the policy?

While I don't disagree with what either Ms. Jacobs or Mr. Florida have said about the importance of cities/regions to economic growth and activity, I do believe it is an interesting question. What do you think? Have you read Ms. Jacobs and/or Mr. Florida? Am I on track or off? I look forward to your comments.

Friday, April 11, 2008

Inflation and Globalization

A side effect from having worked at the Federal Reserve is that my attention automatically gets drawn to certain topics. One of the more common topics is inflation. If one adheres to Milton Friedman's old adage that "inflation is always and everywhere a monetary phenomenon;" one tends to link inflation to monetary policy, and then back to the Fed. This explains, at least in part, my interest in the story I'm referencing.

Yesterday's edition of The Wall Street Journal had, on the front page, an excellent piece about inflation and globalization (now subscriber content). What I found most interesting and valuable was the way it linked rising price pressures around the world. It mentioned wage pressures in Germany, demand pressures in Asia and other developing countries, energy price pressures, and monetary policy. Especially interesting in the last area, was how the decision of several countries to peg their currencies to the U.S. dollar has ended up with those countries essentially importing inflation.

A nation with a currency pegged to the dollar is actually fixing the exchange rate of their currency to the U.S. dollar. This means that under all circumstances, the nation in question will adjust its money supply to maintain a constant value relative to the U.S. dollar - say 7 to 1.

In the U.S., the Federal Reserve has been faced with mounting price pressures at the same time it confronts an economic slowdown evolving out of current credit conditions. Various spokespersons within the Federal Reserve System have stated that the perceived greater risk is a slowdown. Consequently, monetary policy has been expansionary as evidenced by lower short-term interest rates and increased lending by the central bank.

For nations with currencies pegged to the dollar, this has resulted in a looser monetary policy. But these countries have not necessarily been faced with the same economic slowdown. Consequently, more money in their system has translated into higher price pressures.

But the most interesting thing about this article is the global aspect. The inflationary pressures are not restricted to the U.S. and countries with pegged currencies; they are everywhere. In some nations, one of the key benefits of globalization - increased wages - has resulted in increased demand for goods and service, driving up prices. In others, the increased demand for commodities in one part of the world has rippled through to another.

The concepts of money, inflation, interdependence, markets, and economic growth and development are all touched upon the article. Whether you use the article as an assigned or supplemental reading in class, or just read it for your own benefit, I strongly recommend it.

I look forward to your thoughts, as well as your students' reactions.

Thursday, April 10, 2008

Saying Goodbye to a Valuable Resource

I haven't been able to do a lot of posting the past few days because I've been at a conference. My review of Greg Clark's book not withstanding (I actually wrote a good part of that just before I left); my time has been dominated by presenting at and attending sessions or otherwise involved in travel. Consequently, when I got to my office this morning and finally got a chance to look at the backlog of mail, I found out that yesterday's (4/9/08) issue of The Wall Street Journal included the last article by one of my favorite columnists, Jonathan Clements.

Jonathan has been writing a column for the Journal since 1994. I've read most of his "Getting Going" series with amusement and interest. He always does an excellent job of explaining issues related to personal finance in a way that experienced as well as novice readers can benefit. He often provided me with a new perspective using an old and familiar tool.

His final column was no different. He talked about why we all should save and invest for our futures. "Nothing new there," you may say. But by using some simple old tools of economics: opportunity cost, risk/return, and money as a store of value, he provided one of the best cases for saving that I've read in some time. It is succinct and powerful. I would strongly recommend you consider sharing it with your students.

Now, just in case you're just discovering this resource, Clements also produced an online column with links to 10 of his favorite columns from the past. It was a great way for him to say "goodbye." I know that, for me, Wednesday mornings with the Journal won't be the same.

I hope you find them helpful and I look forward to your comments.

Tuesday, April 8, 2008

What I'm Reading

I finally finished reading A Farewell to Alms by Dr. Gregory Clark. I say finally because Clark's book took me a bit longer to read than I would have anticipated, given its size (377 pp). It took longer for two reasons: Clark's writing style in this book is more academic than many of the popular economics books that have come out recently, thus it wouldn't qualify as beach reading. And his thesis is thought-provoking, as well as controversial.

In the book, Clark investigates one of the great puzzles in economic history - the Industrial Revolution. Considering its impact, economists and historians both are still at a loss to answer the questions of "Why then?" and "Why There?" Specifically, "what factors caused the sudden expansion of economic activity at the end of the 18th century?" And a parallel question, "Why in Great Britain, instead of elsewhere?"

The approach Clark takes is to frame things in a Malthusian context. (For those of you unfamiliar with the ideas of Thomas Malthus, check here.) Clark maintains that, until 1800, the world seemed to be in a classic Malthusian trap. As population grew, it would outpace the ability to feed itself. This would reduce life expectancy, which would reduce demand pressures. As costs fell with decreasing demand, real income would rise and, ultimately, population would rebound. But around 1800, the approximate beginning of the Industrial Revolution, things changed dramatically, especially in Great Britain and the United States.

If I read Clark correctly, the "why then?" is due to some changes in the demography. Clark points out that while the population as a whole had been subject to the pressures outlined by Malthus, the pressures were not distributed evenly. hanges in technology and learning had provided some structural changes. These changes had generally raised living standards, and population was growing. But it did not grow evenly - and that is the crucial point. While birth rates were generally elevated across income groups, child survival rates were not. The upper classes fared better than the lower - as one might expect.

The "why there" seems to me to be a function of institutions, both formal an informal. On the formal side, it was the laws of inheritance; and on the informal side, the appreciation and provision of education. Generally, the inheritance laws provided for the eldest son to inherit most of the estate, with some provision for other siblings. These other siblings are the key. Because they did not inherit a large portion of the estate, they often were forced to seek their fortunes elsewhere, among people of a lower class. Because the siblings came from a higher socio-economic group, they brought certain views and expectations with them. They generally did not fall far in the economic strata, and they brought ideas that would change the views others. This often included a different work ethic and a longer-term appreciation for income and what it could bring. It also meant that they brought an appreciation for education and ideas that could spread within their new circle of contacts.

Dr. Clark's research is excellent. He does not rush to build his argument, rather he spends considerable time developing a strong case, layer by layer, for his thesis. Given the somewhat controversial nature of the thesis, this is prudent. Overall, I found this book interesting. I was able to link much of what Clark discussed with ideas I had when I first came read the works of Fernand Braudel. (For those who would like to know more about Braudel, check here.) Braudel was a historian in the middle of the 20th century. He would develop a unique way of writing history, integrating large aspects of economics and sociology in his work. Dubbed the Annales School, Braudel changed history and historiography from personality and event driven to a longer view, integrating the living conditions, beliefs and structures of the wider population. Economics, particularly on a personal level, played a large part in what Braudel wrote. And I think Braudel's view is certainly compatible with, if not generally supportive of what Clark proposes.

I would recommend this book for anyone interested in general economic theory and the Industrial Revolution. As I said before, I would not go so far as to call this a leisurely read - like some current economics books written for general audiences - I would call it an important read, as I think it will generate some controversy.

As a final note, I would recommend you also check out the book chat for this work on the Marginal Revolution blog. It was done in four parts, and you can find them here, here, here, and here.

I look forward to your comments.

Friday, April 4, 2008

An Economic Way of Thinking about Romeo and Juliet - Act Five

For those of you just joining us, we are using an economic way of thinking to examine William Shakespeare's Romeo and Juliet. We started with an introduction last week, March 28, and have been doing an act a day. Today we finish this little exercise with...

Act V
The first scene of the final act finds Romeo in Mantua. There he is met by a messenger from Verona who bears sad tidings – he has seen Juliet lowered into the family crypt. Romeo is understandably distraught, and thus sets up the only financial transaction of the play that we are privy to. Romeo seeks out an apothecary (Remember the convenient shopping?) to purchase a poison. He has chosen to join his Juliet in death and seeks a strong potion to use in committing suicide. At first, the apothecary is reluctant to provide the poison. It seems there are stringent laws in Mantua about dispensing such drugs – providing an incentive against their sale. But Romeo points out that the vendor is poor, starving, and possibly on the verge of death. In Romeo's mind, the prohibition cannot be much of a disincentive to one in such a state. He points out the hard straights the apothecary is in, and secures the poison. The transaction takes place. Romeo chooses to buy. The apothecary chooses to sell. Both choose according to incentives (Romeo wants to die, the apothecary to live). And both face possible costs of this choice in the future.

The second scene offers little in the way of choices. However, it does provide us a key insight into economics and economic thinking. We find in this scene that Friar Lawrence's letter to Romeo, outlining the plot to feign death and allow Juliet to escape to Mantua, was not delivered. Romeo is without a vital piece of information. This actually explains his harsh choice in the previous scene. Economics tells us that we make better choices if we have more information. Given the lack of a vital piece of information (Juliet is faking death); Romeo has chosen based upon incentives that do not correct. His choice, while tragic, is logical if we understand the economic way of thinking.

The final scene takes place in the graveyard. First, Paris arrives with a servant, intending to leave flowers on the grave of his late bride-to-be. Next, Romeo arrives with his friend and servant, Balthasar. Romeo dispatches Balthasar with a letter for his father, explaining his actions. He further charges Balthasar not to return before delivering the letter, under pain of death – a strong incentive one would presume. But it is not strong enough, as Balthasar chooses to stick around and keep an eye on Romeo.

Romeo and Paris then confront each other. Paris misunderstands Romeo's presence, assuming he came to defile the grave of a family enemy. Romeo does not want to fight, but chooses to do so anyway. His incentive appears to be a desire to join Juliet as soon as he can, and Paris stands in the way. Meanwhile, Paris' servant has gone for help. Additionally, Friar Lawrence arrives, hoping to intercept Romeo. He runs into Balthasar who tells him that Romeo is already in the graveyard and has been for some time. But Balthasar, under Romeo's previous incentive, declines to go with the Friar to find and presumably stop Romeo.

Meanwhile, Paris and Romeo have fought, and Paris has lost – the consequence is death. Romeo then chooses to drink his potion and dies next to Juliet. Friar Lawrence arrives too late for Romeo, but just as Juliet stirs. As she awakens, he offers the choice of going to a convent. But this is not a strong enough incentive, as Juliet wants to be with Romeo. She seeks some of the poison, and finding none, takes up a dagger and kills herself. At this point, the graveyard might as well be Grand Central Station. The watchmen arrive, the Prince arrives, the Capulets arrive and Lord Montague arrives – his wife having died of a broken heart over Romeo's exile. Friar Lawrence tells all, from his plan to spirit away a seemingly dead Juliet to join Romeo in Mantua, to the lost communications, and the death of the young lovers. The feud is ended in grief and Montague vows to erect a gold statue of Juliet, in memory of her faithfulness. As the story ends, we are left with a fuller understanding of the costs related to choices made by Romeo and Juliet under the incentives in place. Mercutio, Tybalt, Paris, Lady Montague, Romeo and Juliet all lie dead. These costs were unknown and in the future at the time the choices were made.

Thursday, April 3, 2008

An Economic Way of Thinking about Romeo and Juliet - Act Four

Scene one begins with Paris at the cell of Friar Laurence. They are soon joined by Juliet. It seems that the Friar’s cell is a popular destination. Paris and Juliet exchange greetings and talk about the impending marriage. Then he leaves. Upon which, Juliet begins speaking of a wide variety of alternative choices to marrying Paris. Unfortunately, they all seem to end with her dying. The Friar feels that the cost in all of these may be too high. He offers one more choice. She should agree to marry Paris, but on the eve of the wedding, take a potion that will make her appear to be dead. Once she’s placed in the family burial chamber, Romeo will come and take her away to live in with him in Mantua. We see a new choice to be made with the incentive being a new life with Romeo. What is the cost? It’s in Mantua. (Actually, I hear Mantua is quite nice – convenient shopping, nice restaurants, good schools…..)

Back at Casa Capulet, we open scene two with another party to plan. This one will be the wedding feast for Juliet. Juliet enters the scene and indicates she has chosen to acquiesce to her father’s judgment after being shown the errors of her ways by Friar Lawrence. Although it is a complete fabrication, it basically lays out a plausible incentive structure for a choice to agree to marry Paris. Although it is a ruse, it is a skillful ruse – the church and dad’s judgment being strong incentives, at least to dad. And so scene two presents two choices by Juliet: one actual (to lie to her father) and one apparent (to submit to the logic of her father and Friar Lawrence). The incentive structure is still life with Romeo. And that structure is now making it easier for Juliet to choose.

At the beginning of scene three, we find Juliet and her nurse choosing her wedding attire. Lady Capulet joins them briefly, and Juliet dismisses both saying she desires to be alone with her thoughts and prayers. She then focuses on the potion given to her by Friar Lawrence. And in the course of choosing to drink the potion, she lists a number of possible costs or consequences that may lie in the future. "What if the potion doesn’t work – will she end up married? Or will she resort to a dagger? What if the Friar has tricked her and substituted a poison to kill her and save his reputation? What if she wakes in the tomb before Romeo arrives and suffocates?" In her mind, these are possible costs attending the choice to drink the potion. But her strongest incentive is to be with Romeo. In her mind, the possible costs are outweighed by the possibility of life with her love. So she chooses to drink the potion.

Scene four, on the other hand, offers little in the way of decision-making, unless we include Lord Capulet’s choice to stay awake all night supervising the preparation of the wedding feast, while the servants, his wife and Nurse are doing all the work.

In scene five, we see the costs to others of Juliet's choice to drink the potion. (In economics we would talk about externalities – costs borne by others outside the action.) Juliet did not think of how the feigned death would affect her parents, Paris, and the others involved in the wedding plans. But here we see that costs of a choice are in the future – and not always foreseen. And so, we go to the final act.

Wednesday, April 2, 2008

An Economic Way of Thinking about Romeo and Juliet - Act Three

At the beginning of scene one, we find Benvolio and Mercutio in the town square. They are basically debating whether to go home, as the weather is hot and people's moods are hotter. And Benvolio, at least, is concerned that a fight, given the proper circumstances (i.e. any circumstances at all) Mercutio will end up fighting. Apparently Mercutio fights because he enjoys it. He chooses based on some incentive system – he may have a death wish, he may be an adrenaline junky, he may have yet to lose a fight and thus have an unrealistic view of his own mortality (contrary to the first idea).

Tybalt then appears in the square with some of his homeboys. Tybalt seeks Romeo to settle some imagined slight. Romeo arrives but declines to fight. But Mercutio gives in to his value system and draws on Tybalt. Soon after, the incentive of death to the head of house is forgotten (even though Romeo reminds them) and fight ensues. First Mercutio is killed as Romeo chooses to intervene and prevent bloodshed. Tybalt runs away, but returns to seek Romeo. But with the death of his friend Mercutio, Romeo's incentive structure is now changed. He fights and slays Tybalt. Romeo then flees. This leaves Benvolio to explain all to the Capulets and the Prince. The Prince, facing a cost from a previous choice, changes the rules again, deciding enough blood has been shed and nothing may be gained by taking the heads of the feuding houses. Thus he chooses to banish Romeo. This scene offers many examples of people choosing, (to not fight or to fight), and of people responding to incentives, (whether it be an ineffectual incentive – the death of someone else, or a more effective incentive – revenge). And the choices have costs. For Mercutio, the decision to pick a fight cost his life. For Tybalt, the choice of returning to look for Romeo cost his life. And for Romeo, the choice of fighting and killing Tybalt has cost him his citizenship to Verona. All costs were in the future (remember, the Prince has chosen not to enforce a previous decision against fighting – perhaps the costs of the previous choice were too high - and I suspect none of the fighters thought they would lose). And we've not yet tallied all the costs of Romeo's choice, as we shall see.

We now go to Capulet's orchard, the setting for scene two. Here, Juliet awaits her husband, but instead is visited by her nurse who brings word of the death of Tybalt (Juliet's cousin) at the hand of Romeo and Romeo's subsequent banishment. At word of this, Juliet must choose where her greater allegiance lies – with her old family or her new. Juliet chooses, and again, the cost of that choice lies in the future.

We find Romeo at Friar Lawrence's in scene three. Here, upon finding he's been banished to Mantua, Romeo bemoans his fate – one worse than death in his eyes. What appears to be the full future cost of his decision to kill Tybalt is now apparent to him. He must live without his Juliet. Juliet's nurse brings news of her mistress's distress (now calling Tybalt, now Romeo), which further upsets Romeo. But the good Friar makes Romeo see all is not lost. The Friar proposes Romeo go to Mantua and he (the Friar) will try to get the Prince to rescind his choice banishing Romeo, while informing the feuding families of the marriage. And at some time in the future, Romeo will be able to return. Thus, if Romeo chooses to accept banishment, the immediate future cost of the choice is life in Mantua. The incentive is life with Juliet.

We now head back to Capulet's house for another short scene, a meeting between Lord and Lady Capulet and the suitor, Paris. Here, Lord Capulet assures Paris that Juliet's choice will be moved by her father's judgment, and the wedding bells will ring sometime soon. Lord Capulet is confident that his judgment is sufficient incentive for his daughter on the question of marriage. The "cost" of that choice is a wedding in the future.

Scene five is the last scene in this act. It opens with Romeo and Juliet awakening after their wedding night. They debate whether various portents are of the night or the morning. But Nurse arrives and removes all doubt. It's morning and Juliet's mom is on her way to visit her daughter. Romeo leaves, and Juliet's mom arrives. She informs Juliet that marriage to Paris is in the offing. Juliet will have none of that. Lord Capulet then arrives and finds that his judgment is not sufficient incentive for Juliet to choose Paris. (Of course, he doesn’t know she's already married – an institution that, along with love of Romeo, presents a large incentive to choice.) Lord and Lady Capulet then place a new cost on Juliet's choice to reject Paris. They will, in the near future, turn her out of the house. (This actually presents a positive rather than negative incentive, as it would free Juliet to join Romeo in nearby Mantua.)

As Act III ends, people are choosing and offering incentives with costs in the future all over the place. This play is becoming a playground for studying choice and decision-making.

Tuesday, April 1, 2008

No Surprise in This Surprise

Yesterday, U.S. Secretary of the Treasury, Henry M. Paulson, Jr., announced a proposal that hailed as a sweeping reform of the U.S. financial system. In an effort to restore strength in the nation's financial system, the secretary set forth a list of proposed changes. Some of them would create new Federal entities. Others would subordinate existing agencies to other Federal agencies, changing their mission in some respect. Still others would move activities previously in the hands of the states under the supervision of Federal oversight. Many of these aforementioned proposals seek to give more responsibility to the Federal Reserve System

I am not in a position to, nor am I going to comment on whether this organizational structure is a good one or not. However, I do think that the proposed structure should not be a surprise to anyone with a memory that goes back to the previous administration. In 1999, the Congress passed and then President Clinton signed the Gramm-Leach-Bliley bill, also known as the Financial Services Modernization Act of 1999. This Act revoked the Glass-Steagall Act, passed in the 1930s. Glass-Steagall had, among other things, separated commercial and investment banking in the wake of the 1929 Stock Market Crash and the onset of the Great Depression. But Gramm-Leach-Bliley removed that separation. Indeed, it opened the financial markets up to new combinations - allowing banks to buy stock brokerages and insurance companies; brokerages to purchase banks and insurance companies; and insurance companies to set up or purchase brokerages and banks. At the time, many people feared a wide-scale rush to conglomerate that never happened. But the important part of the legislation, at least for purposes of this post, was to allow the existing regulatory structure to stay in place, but to name an "umbrella regulator" for some of the ensuing combinations. The "umbrella regulator" was given responsibility for overseeing and/or coordinating the activity of other regulators when it came to banks and bank holding companies that combined the firms.

And here's the relevance to this post. That "umbrella regulator" was the Federal Reserve. Part of the reasoning, as I understood it back then, was the potential for combined firms to present a problem for banks, and ultimately for that to manifest itself at the Fed's Discount Window. Now, to my knowledge, the increased responsibility did not result in a huge expansion of the Fed's staff or powers. This may be because the anticipated amalgamation of financial firms never came to fruition. But the framework, at least in theory, was put in place. In my opinion and given the situation, the resulting restructuring that we now are hearing about is the logical next step from Gramm-Leach-Bliley.

This is a significant restructuring, to be sure. But it should not be labeled as a "surprise," at least not in my opinion. But, as always, your opinions and comments are welcome. Do you think this is a "historic" moment in U.S. financial history? Or is it another step in the evolution of the nation's central bank?

An Economic Way of Thinking about Romeo and Juliet - Act Two

Scene one finds Mercutio and Benvolio seeking for Romeo. They still think he is enamored of Rosaline. But they are wrong. As they disappear, the scene melts into the second scene – the famous balcony scene. And in this scene, there is much ado about choosing. They debate whether to choose other names. They choose to be with one another rather than avoid discovery – even though the choice has a cost. They ultimately choose to marry. The young lovers respond to the incentives – each other’s company and going against the institutions of familial prohibitions. This last choice is not unusual, certainly not for teenagers. And it is a choice grounded in something economists refer to as “psychic income.” This is an emotional profit from an interchange or transaction. And it provides to be as valid an incentive as monetary income. Our lovers choose, and in choosing respond to incentives.

The third scene is fairly short. It takes place in Friar Lawrence’s cell. Romeo arrives and informs the good Friar that Rosaline no longer is the object of his affection. He then requests that the cleric unite him and Juliet in matrimony. A choice thus appears. The good friar’s incentive is to unite two feuding houses and thus restore peace to the city. Given his profession, it’s hard to see how he can resist. (Actually, we can make a case that given his profession it’s hard to see why he would accept.) But incentives act differently on individuals according to their values. Once again, we have incentives (bringing peace to Verona through marriage), and choice (agreeing to unite Romeo and Juliet in matrimony).

Likewise, scene four offers little for us to analyze. A good portion of the scene is made up of taunting and jesting between Mercutio, Benvolio, and Romeo. At some point they are joined by Juliet’s Nurse who brings tidings to Romeo. Romeo, in turn, asks the nurse to bring Juliet to the chambers of Friar Lawrence for the wedding ceremony, and later to provide a rope so that Romeo can scale the Capulet wall and join Juliet for a honeymoon. The nurse readily agrees. The only real example of economic thinking in this scene is a brief speech by Romeo in which he describes the circumstances in which he would draw a weapon and come to the Nurse’s aide. In short, we have some insight into how people choose. Specifically, we now know some of the incentive that would move Romeo to choose to fight. This is not to say it is the only incentive, as we shall see. But, it does allow us to examine some of his values.

Scene five is short but has a clear statement of choice. Juliet’s nurse brings Romeo’s message. She recounts the incentives for choosing Romeo – many of which are physical. And then presents Juliet with the decision, telling her that if she would marry Romeo, she must go to Friar Lawrence’s cell. We are actually left hanging, but Nurse implies that Juliet is leaving, for she goes to find the rope ladder. The incentive (marriage and being with her love) is in place and Juliet chooses.