Extra Credit Assignment
Worth 30 points
Due by the date on the homepage of the course.
The Veranda (or a Balanced) Approach to Online Instruction
I wish to share with you why I believe in the Veranda (or balanced) Approach to learning. The house where my family lives is in the dessert; in an affluent retirement community. Our house is a typical Spanish style rectangular home, but over the past few years we have added two major front and back additions. We added arches at the front and wooden trellis covered with grape vines at the back. Not only do these new features give our home a more ascetic appeal but they provide a more functional purpose too. Instead our house is not directly exposed to the sun thus making our heating or cooling bills less. This Veranda Approach has not only become an important part of my home but of my teaching and how I live my life too. I believe so strongly in creating life balance just as my two Veranda’s do for my home, that I not only do I teach online, but teach a few on ground economics classes and maintain a small golf club selling business too. Life is about balance; I meditate 20 minutes a day, do 1000 sit-ups and jog 5 miles a day.
I not only teach online at Barstow Community College but I teach managerial economics to MBA’s too. At one particular school where I teach online, I received the most valuable teaching award out of 60 other graduate teachers. All I did to receive this award was to apply my "Veranda Approach". It is simply this give the students more than they asked for. I do the same every day of my life (creating a more balanced lifestyle). I have a close friend who owns 5 car dealerships. We often talk about marketing and what makes the sale of a high end vehicle. He tells me that what sells a Cadillac will often be a brand new set of golf clubs he throws in to sweeten the deal. He tells me that it is more often the clubs and the car together that makes a patron return to his showroom again and again.
My point here is this, from an incremental point of view by offering a few simple additions to our class your knowledge will be enhanced. This summer this graduate school paid for me to attend their graduation services and receive my award. While there I purposely asked students who voted for me as their number one online pick why me? What I learned from these students surprised me. I not only teach economics but I have taught them about emotional quotient or EQ as psychologists call it. Emotional quotient suggests that those employees who are more mature job seekers have a higher probability of receiving a job promotions or a raise. Just like the golf bags that clinched the Cadillac sale, EQ gave me the edge over 60 other proficient professors. My goal in our class is by making a few simple additions here and there that you would receive the very same top flight economics experience from Barstow Community College as you would from Stanford. However, we will do it in such a way that it won’t require all their readings.
Also, with my EQ additions rather than adding my own writings I included the writings of people prominent in their fields. I also tried to keep these writings brief so your reading time is less. At the end of both A: Comparative Economic Systems and B International Business, I will simply ask you no more that about 5 to 6 thought provoking questions that you will answer and e-mail back so I know you understood my material. Here are the two Macro topics of study. The first is A. Comparative Economic Systems and the second is B. International Economics. While you answer these questions you can make your answers brief but make them as detailed as possible. Dr. Steve McQueen
A. Comparative Economic Systems
Capitalism
Capitalism, a term of disparagement coined by socialists in the mid-nineteenth century, is a misnomer for "economic individualism," which Adam Smith earlier called "the obvious and simple system of natural liberty." Economic individualism's basic premise is that the pursuit of self-interest and the right to own private property are morally defensible and legally legitimate. Its major corollary is that the state exists to protect individual rights. Subject to certain restrictions, individuals (alone or with others) are free to decide where to invest, what to produce or sell, and what prices to charge, and there is no natural limit to the range of their efforts in terms of assets, sales and profits, or the number of customers, employees, and investors, or whether they operate in local, regional, national, or international markets.
The emergence of capitalism is often mistakenly linked to a Puritan work ethic. German sociologist Max Weber, writing in 1903, located the catalyst for capitalism in seventeenth-century England, where members of a religious sect, the Puritans, under the sway of John Calvin's doctrine of predestination, channeled their energies into hard work, reinvestment, and modest living, and then carried these attitudes to New England. Weber's thesis breaks down, however. The same attitudes toward work and savings are exhibited by Jews and Japanese, whose value systems contain no Calvinist component. Moreover, Scotland in the seventeenth century was simultaneously orthodox Calvinist and economically stagnant.
A better explanation of the Puritans' diligence is that by refusing to swear allegiance to the established Church of England, they were barred from activities and professions to which they otherwise might have been drawn—land ownership, law, the military, civil service, universities—so they focused on trade and commerce. A similar pattern of exclusion or ostracism explains why Jews and other racial and religious minorities in other countries and later centuries tended to concentrate on retail businesses and money lending.
In early nineteenth-century England the most visible face of capitalism was the textile factories that hired women and children. Critics (Richard Oastler and Robert Southey, among others) denounced the mill owners as heartless exploiters. They described the working conditions—long hours, low pay, monotonous routine—as if they were unprecedented. Believing that poverty was new, not merely more visible in crowded towns and villages, critics compared contemporary times unfavorably with earlier centuries. Their claims of increasing misery, however, were based on ignorance of how squalid life actually had been earlier. Before children began earning money working in factories, they had been sent to live in parish poorhouses, apprenticed as unpaid household servants, rented out for backbreaking agricultural labor, or became beggars, vagrants, thieves, and prostitutes. The precapitalist "good old days" simply never existed (see Industrial Revolution and the Standard of Living).
Nonetheless, by the 1820s and 1830s the growing specter of child labor and "dark satanic mills" generated vocal opposition to these unbridled examples of self-interest and the pursuit of profit. Some critics urged legislative regulation of wages and hours, compulsory education, and minimum-age limits for laborers. Others offered more radical attacks and alternatives. The most vociferous were the socialists, who aimed to eradicate individualism, the name that preceded capitalism.
Socialist theorists repudiated individualism's leading tenets: that individual possesses inalienable rights, that society should not restrain individuals from pursuing their own happiness, and that economic activity should not be regulated by government. Instead, they proclaimed an organic conception of society. They stressed ideals such as brotherhood, community, and social solidarity and set forth detailed blueprints for model utopian colonies in which collectivist values would be institutionalized.
The short life span of these utopian societies acted as a brake on the appeal of socialism. But its ranks swelled once Karl Marx offered a new "scientific" version, proclaiming that he had discovered the laws of history and that socialism inevitably would replace capitalism. Beyond offering sweeping promises that socialism would create economic equality, eradicate poverty, end specialization, and abolish money, Marx supplied no details at all about how a future socialist society would be structured or operates.
Even nineteenth-century economists—in England, America, and Western Europe—, who were supposedly capitalism's defenders, did not defend capitalism effectively because they did not understand it. They came to believe that the most defensible economic system was one of "perfect" or "pure" competition. Under perfect competition all firms are small scale, products in each industry are homogeneous, consumers are perfectly informed about what is for sale and at what price, and all sellers are what economists call price takers (that is, they have to "take" the market price and cannot charge a higher one for their goods).
Clearly, these assumptions were at odds with both common sense and the reality of market conditions. Under real competition, which is what capitalism delivered, companies are rivals for sales and profits. This rivalry leads them to innovate in product design and performance, to introduce cost-cutting technology, and to use packaging to make products more attractive or convenient for customers. Unbridled rivalry encourages companies to offer assurances of security to imperfectly informed consumers, by means such as money-back guarantees or product warranties and by building customer loyalty through investing in their brand names and reputations (see Advertising and Brand Names).
Companies that successfully adopted these techniques of rivalry were the ones that grew, and some came to dominate their industries, though usually only for a few years until other firms found superior methods of satisfying consumer demands. Neither rivalry nor product differentiation occurs under perfect competition, but they happen constantly under real flesh-and-blood capitalism.
The leading American industrialists of the late nineteenth century were aggressive competitors and innovators. To cut costs and thereby reduce prices and win a larger market share, Andrew Carnegie eagerly scrapped his huge investment in Bessemer furnaces and adopted the open hearth system for making steel rails. In the oil-refining industry John D. Rockefeller embraced cost cutting by building his own pipeline network, manufacturing his own barrels, and hiring chemists to remove the vile odor from abundant, low-cost crude oil. Gustavus Swift challenged the existing network of local butchers when he created assembly-line meat-packing facilities in Chicago and built his own fleet of refrigerated railroad cars to deliver low-price beef to distant markets. Local merchants also were challenged by Chicago-based Sears Roebuck and Montgomery Ward, which pioneered mail-order sales on a money-back, satisfaction-guaranteed basis.
Small-scale producers denounced these innovators as "robber barons," accused them of monopolistic practices, and appealed to Congress for relief from relentless competition. Beginning with the Sherman Act (1890), Congress enacted antitrust laws that were often used to suppress cost cutting and price slashing, based on acceptance of the idea that an economy of numerous small-scale firms was superior to one dominated by a few large, highly efficient companies operating in national markets (see Antitrust).
Despite these constraints, which worked sporadically and unpredictably, the benefits of capitalism were widely diffused. Luxuries quickly were transformed into necessities. First, the luxuries were cheap cotton clothes, fresh meat, and white bread; then sewing machines, bicycles, sporting goods, and musical instruments; then automobiles, washing machines, clothes dryers, and refrigerators; then telephones, radios, televisions, air conditioners, and freezers; and most recently, microwave ovens, videocassette recorders, answering machines, personal computers, sophisticated cameras, and compact disc players.
That these amenities had become available to most people did not cause capitalism's critics to recant, or even relent. Instead, they ingeniously reversed themselves. Marxist philosopher Herbert Marcuse proclaimed that the real evil of capitalism is prosperity, because it seduces workers away from their historic mission—the revolutionary overthrow of capitalism—by supplying them with cars and household appliances, which he called "tools of enslavement." Some critics reject capitalism by extolling "the simple life" and labeling prosperity as mindless materialism. Critics such as John Kenneth Galbraith and Vance Packard attacked the legitimacy of consumer demand, asserting that if goods had to be advertised in order to sell, they could not be serving any authentic human needs. They charged that consumers are brainwashed robots of Madison Avenue who crave whatever the giant corporations choose to produce and advertise. They complained that the "public sector" was being starved while frivolous private desires were being satisfied. And having seen that capitalism reduced poverty, instead of intensifying it, critics such as Gar Alperovitz and Michael Harrington proclaimed equality as the highest moral value, calling for higher taxes on incomes and inheritances to massively redistribute wealth, not only nationally but also internationally.
Other critics (like Ralph Nader and Mark Green) focused their fire on giant corporations, charging that they are illegitimate institutions because they do not conform to the model of small-scale, owner-managed firms that Adam Smith extolled in 1776. In fact, giant corporations are fully consistent with capitalism, which does not imply any particular configuration of firms in terms of size or legal form. They attract capital from thousands (sometimes millions) of investors who are strangers to each other and who entrust their savings to the managerial expertise of others in exchange for a share of the resulting profits.
In an influential 1932 book, The Modern Corporation and Private Property, Adolf A. Berle, Jr., coined the phrase "splitting of the atom of ownership" to lament the fact that investment and management had become two distinct elements. In fact the process is merely an example of the specialization of function or division of labor that occurs so often under capitalism. Far from being an abuse or defect, giant corporations are an eloquent testimonial to the ability of individuals to engage in large-scale, long-range cooperation for their mutual benefit and enrichment.
As noted earlier, the freedoms to invest, to decide what to produce and to decide what to charge have always been restricted. A fully free economy (true laissez-faire) never has existed, but governmental authority over economic activity has sharply increased since the eighteenth century, and especially since the Great Depression. Originally, local authorities fixed the prices of necessities, such as bread and ale, bridge and ferry tolls, or fees at inns and mills, but most products and services were unregulated. By the late nineteenth century governments were setting railroad freight rates and the prices charged by grain elevator operators, because these businesses had become "affected with a public purpose." By the 1930s the same criterion was invoked to justify price controls over milk, ice, and theater tickets.
Simultaneously, from the eighteenth century on, government began to play a more active, interventionist role in offering benefits to business, such as tax exemptions, bounties or subsidies to grow certain crops, and tariff protection so domestic firms would devote capital to manufacturing goods that otherwise had to be imported. Special favors became entrenched and hard to repeal because the recipients were organized while consumers, who bore the burden of higher prices, were not.
Once safe from foreign competition behind these barriers to free trade, some U.S. producers—steel and auto manufacturers, for example—stagnated. They failed to adopt new technologies or to cut costs until low-cost, low-price overseas rivals—the Japanese, especially—challenged them for their customers. They responded initially by asking Congress for new favors—higher tariffs, import quotas, and loan guarantees—and pleading with consumers to "buy American" and thereby save domestic jobs. Slowly, but inevitably, they began the expensive process of catching up with foreign companies so they could try to recapture their domestic customers.
Today the United States, once the citadel of capitalism, is a "mixed economy" in which government bestows favors and imposes restrictions with no clear or consistent principle in mind. As Soviet Russia and Eastern Europe struggle to embrace free-market ideas and institutions, they can learn from American (and British) experience about not only the benefits that flowed from economic individualism, but also the burden of regulations that became impossible to repeal and trade barriers that were hard to dismantle. If the history of capitalism proves one thing, it is that the process of competition does not stop at national borders. As long as individuals anywhere perceive a potential for profits, they will amass the capital, produce the product, and circumvent the cultural and political barriers that interfere with their objectives.
About the Author
Robert Hessen, a specialist in business and economic history, is a senior research fellow at Stanford University's Hoover Institution. He also teaches in Stanford's Graduate School of Business.
Free Market Economics
Free market is a summary term for an array of exchanges that take place in society. Each exchange is undertaken as a voluntary agreement between two people or between groups of people represented by agents. These two individuals (or agents) exchange two economic goods, either tangible commodities or nontangible services. Thus, when I buy a newspaper from a news dealer for fifty cents, the news dealer and I exchange two commodities: I give up fifty cents, and the news dealer gives up the newspaper. Or if I work for a corporation, I exchange my labor services, in a mutually agreed way, for a monetary salary; here the corporation is represented by a manager (an agent) with the authority to hire.
Both parties undertake the exchange because each expects to gain from it. Also, each will repeat the exchange next time (or refuse to) because his expectation has proved correct (or incorrect) in the recent past. Trade, or exchange, is engaged in precisely because both parties benefit; if they did not expect to gain, they would not agree to the exchange.
This simple reasoning refutes the argument against free trade typical of the "mercantilist" period of sixteenth-to eighteenth-century Europe, and classically expounded by the famed sixteenth-century French essayist Montaigne. The mercantilists argued that in any trade, one party can benefit only at the expense of the other, that in every transaction there is a winner and a loser, an "exploiter" and an "exploited." We can immediately see the fallacy in this still-popular viewpoint: the willingness and even eagerness to trade means that both parties benefit. In modern game-theory jargon, trade is a win-win situation, a "positive-sum" rather than a "zero-sum" or "negative-sum" game.
How can both parties benefit from an exchange? Each one values the two goods or services differently, and these differences set the scene for an exchange. I, for example, am walking along with money in my pocket but no newspaper; the news dealer, on the other hand, has plenty of newspapers but is anxious to acquire money. And so, finding each other, we strike a deal.
Two factors determine the terms of any agreement: how much each participant values each good in question, and each participant's bargaining skills. How many cents will exchange for one newspaper, or how many Mickey Mantle baseball cards will swap for a Babe Ruth, depends on all the participants in the newspaper market or the baseball card market—on how much each one values the cards as compared to the other goods he could buy. These terms of exchange, called "prices" (of newspapers in terms of money, or of Babe Ruth cards in terms of Mickey Mantles), are ultimately determined by how many newspapers, or baseball cards, are available on the market in relation to how favorably buyers evaluate these goods. In shorthand, it occurs by the interaction of their supply with the demand for them.
Given the supply of a good, an increase in its value in the minds of the buyers will raise the demand for the good, more money will be bid for it, and its price will rise. The reverse occurs if the value, and therefore the demand, for the good will fall. On the other hand, given the buyers' evaluation, or demand, for a good, if the supply increases, each unit of supply—each baseball card or loaf of bread—will fall in value, and therefore, the price of the good will fall, then the reverse occurs if the supply of the good decreases.
The market, then, is not simply an array, but a highly complex, interacting latticework of exchanges. In primitive societies, exchanges are all barter or direct exchange. Two people trade two directly useful goods, such as horses for cows or Mickey Mantles for Babe Ruth’s. But as a society develops, a step-by-step process of mutual benefit creates a situation in which one or two broadly useful and valuable commodities are chosen on the market as a medium of indirect exchange. This money-commodity, generally but not always gold or silver, is then demanded not only for its own sake, but even more to facilitate a re-exchange for another desired commodity. It is much easier to pay steelworkers not in steel bars, but in money, with which the workers can then buy whatever they desire. They are willing to accept money because they know from experience and insight that everyone else in the society will also accept that money in payment.
The modern, almost infinite latticework of exchanges, the market, is made possible by the use of money. Each person engages in specialization, or a division of labor, producing what he or she is best at. Production begins with natural resources, and then various forms of machines and capital goods, until finally; goods are sold to the consumer. At each stage of production from natural resource to consumer good, money is voluntarily exchanged for capital goods, labor services, and land resources. At each step of the way, terms of exchanges, or prices, are determined by the voluntary interactions of suppliers and demanders. This market is "free" because choices, at each step, are made freely and voluntarily.
The free market and the free price system make goods from around the world available to consumers. The free market also gives the largest possible scope to entrepreneurs, who risk capital to allocate resources so as to satisfy the future desires of the mass of consumers as efficiently as possible. Saving and investment can then develop capital goods and increase the productivity and wages of workers, thereby increasing their standard of living. The free competitive market also rewards and stimulates technological innovation that allows the innovator to get a head start in satisfying consumer wants in new and creative ways.
Not only is investment encouraged, but perhaps more important, the price system, and the profit-and-loss incentives of the market, guide capital investment and production into the proper paths. The intricate latticework can mesh and "clear" all markets so that there are no sudden, unforeseen, and inexplicable shortages and surpluses anywhere in the production system.
But exchanges are not necessarily free. Many are coerced. If a robber threatens you with "Your money or your life," your payment to him is coerced and not voluntary, and he benefits at your expense. It is robbery, not free markets, that actually follows the mercantilist model: the robber benefits at the expense of the coerced. Exploitation occurs not in the free market, but where the coercer exploits his victim. In the long run, coercion is a negative-sum game that leads to reduced production, saving, and investment, a depleted stock of capital, and reduced productivity and living standards for all, perhaps even for the coercers themselves.
Government, in every society, is the only lawful system of coercion. Taxation is a coerced exchange, and the heavier the burden of taxation on production, the more likely it is that economic growth will falter and decline. Other forms of government coercion (e.g., price controls or restrictions that prevent new competitors from entering a market) hamper and cripple market exchanges, while others (prohibitions on deceptive practices, enforcement of contracts) can facilitate voluntary exchanges.
The ultimate in government coercion is socialism. Under socialist central planning the socialist planning board lacks a price system for land or capital goods. As even socialists like Robert Heilbroner now admit (see Socialism), the socialist planning board therefore has no way to calculate prices or costs or to invest capital so that the latticework of production meshes and clears. The current Soviet experience, where a bumper wheat harvest somehow cannot find its way to retail stores, is an instructive example of the impossibility of operating a complex, modern economy in the absence of a free market. There was neither incentive nor means of calculating prices and costs for hopper cars to get to the wheat, for the flour mills to receive and process it, and so on down through the large number of stages needed to reach the ultimate consumer in Moscow or Sverdlovsk. The investment in wheat is almost totally wasted.
Market socialism is, in fact, a contradiction in terms. The fashionable discussion of market socialism often overlooks one crucial aspect of the market. When two goods are indeed exchanged, what is really exchanged is the property titles in those goods. When I buy a newspaper for fifty cents, the seller and I are exchanging property titles: I yield the ownership of the fifty cents and grant it to the news dealer, and he yields the ownership of the newspaper to me. The exact same process occurs as in buying a house, except that in the case of the newspaper, matters are much more informal, and we can all avoid the intricate process of deeds, notarized contracts, agents, attorneys, mortgage brokers, and so on. But the economic nature of the two transactions remain the same.
This means that the key to the existence and flourishing of the free market is a society in which the rights and titles of private property are respected, defended, and kept secure. The key to socialism, on the other hand, is government ownership of the means of production, land, and capital goods. Thus, there can be no market in land or capital goods worthy of the name.
Some critics of the free-market argue that property rights are in conflict with "human" rights. But the critics fail to realize that in a free-market system, every person has a property right over his own person and his own labor, and that he can make free contracts for those services. Slavery violates the basic property right of the slave over his own body and person, a right that is the groundwork for any person's property rights over nonhuman material objects. What's more, all rights are human rights, whether it is everyone's right to free speech or one individual's property rights in his own home.
A common charge against the free-market society is that it institutes "the law of the jungle," or a "dog eat dog," that it spurns human cooperation for competition, and that it exalts material success as opposed to spiritual values, philosophy, or leisure activities. On the contrary, the jungle is precisely a society of coercion, theft, and parasitism, a society that demolishes lives and living standards. The peaceful market competition of producers and suppliers is a profoundly cooperative process in which everyone benefits, and where everyone's living standard flourishes (compared to what it would be in an un-free society). And the undoubted material success of free societies provides the general affluence that permits us to enjoy an enormous amount of leisure as compared to other societies, and to pursue matters of the spirit. It is the coercive countries with little or no market activity, notably under communism, where the grind of daily existence not only impoverishes people materially, but deadens their spirit.
About the Author
Murray N. Rothbard, who died in 1995, was the S. J. Hall Distinguished Professor of Economics at the University of Nevada in Las Vegas. He was also the leading Austrian economist of the last half of the 20th century.
Socialism
Socialism—defined as a centrally planned economy in which the government controls all means of production—was the tragic failure of the twentieth century. Born of a commitment to remedy the economic and moral defects of capitalism, it has far surpassed capitalism in both economic malfunction and moral cruelty. Yet the idea and the ideal of socialism linger on. Whether socialism in some form will eventually return as a major organizing force in human affairs is unknown, but no one can accurately appraise its prospects who have not taken into account the dramatic story of its rise and fall.
The Birth of Socialist Planning
It is often thought that the idea of socialism derives from the work of Karl Marx. In fact, Marx wrote only a few pages about socialism, as either a moral or a practical blueprint for society. The true architect of a socialist order was Lenin, who first faced the practical difficulties of organizing an economic system without the driving incentives of profit seeking or the self-generating constraints of competition. Lenin began from the long-standing delusion that economic organization would become less complex once the profit drive and the market mechanism had been dispensed with—"as self-evident," he wrote, as "the extraordinarily simple operations of watching, recording, and issuing receipts, within the reach of anybody who can read and write and knows the first four rules of arithmetic."
In fact, economic life pursued under these first four rules rapidly became so disorganized that within four years of the 1917 revolution, Soviet production had fallen to 14 percent of its pre-revolutionary level. By 1921 Lenin was forced to institute the New Economic Policy (NEP), a partial return to the market incentives of capitalism. This brief mixture of socialism and capitalism came to an end in 1927 after Stalin instituted the process of forced collectivization that was to mobilize Russian resources for its leap into industrial power.
The system that evolved under Stalin and his successors took the form of a pyramid of command. At its apex was Gosplan, the highest state planning agency, which established such general directives for the economy as the target rate of growth, the allocation of effort between military and civilian outputs, between heavy and light industry, or among various regions. Gosplan transmitted the general directives to successive ministries of industrial and regional planning, whose technical advisers broke down the overall national plan into directives assigned to particular factories, industrial power centers, collective farms, or whatever. These thousands of individual subplans were finally scrutinized by the factory managers and engineers who would eventually have to implement them. Thereafter, the blueprint for production reascended the pyramid, together with the suggestions, emendations, and pleas of those who had seen it. Ultimately, a completed plan would be reached by negotiation, voted on by the Supreme Soviet, and passed into law.
Thus, the final plan resembled an immense order book, specifying the nuts and bolts, steel girders, grain outputs, tractors, cotton, cardboard, and coal that, in their entirety, constituted the national output. In theory such an order book should enable planners to reconstitute a working economy each year—provided, of course, that the nuts fitted the bolts, the girders were of the right dimensions, the grain output was properly stored, the tractors operable, and the cotton, cardboard, and coal of the kinds needed for their manifold uses. But there was a vast and widening gap between theory and practice.
Problems Emerge
The gap did not appear immediately. In retrospect, we can see that the task facing Lenin and Stalin in the early years was not so much economic as quasi-military—mobilizing a peasantry into a work force to build roads and rail lines, dams and electric grids, steel complexes and tractor factories. This was a formidable assignment, but far less formidable than what would confront socialism fifty years later, when the task was not so much to create enormous undertakings, but relatively self-contained ones, and to fit all the outputs into a dovetailing whole.
Through the sixties the Soviet economy continued to report strong overall growth—roughly twice that of the United States—but observers began to spot signs of impending trouble. One was the difficulty of specifying outputs in terms that would maximize the well-being of everyone in the economy, not merely the bonuses earned by individual factory managers for "over fulfilling" their assigned objectives. The problem was that the plan specified outputs in physical terms. One consequence was that managers maximized yardages or tonnages of output, not its quality. A famous cartoon in the satirical magazine Krokodil showed a factory manager proudly displaying his record output, a single gigantic nail suspended from a crane.
As the economic flow became increasingly clogged and clotted, production took the form of "storming" at the end of each quarter or year, when every resource was pressed into use to meet preassigned targets. The same rigid system soon produced expediters, or tolkachi, to arrange shipments to harassed managers who needed unplanned—and therefore unobtainable—inputs to achieve their production goals. Worse, in the absence of the right to buy their own supplies or to hire or fire their own workers, factories set up fabricating shops, then commissaries, and finally their own worker housing to maintain control over their own small bailiwicks.
It is not surprising that this increasingly Byzantine system began to create serious dysfunctions beneath the overall statistics of growth. During the sixties the Soviet Union became the first industrial country in history to suffer a prolonged peacetime fall in average life expectancy, a symptom of its disastrous misallocation of resources. Military research facilities could get whatever they needed, but hospitals were low on the priority list. By the seventies the figures clearly indicated a slowing of overall production. By the eighties the Soviet Union officially acknowledged a near end to growth that was, in reality, an unofficial decline. In 1987 the first official law embodying perestroika—restructuring—was put into effect. President Mikhail Gorbachev announced his intention to revamp the economy from top to bottom by introducing the market, reestablishing private ownership, and opening the system to free economic interchange with the West. Seventy years of socialist rise had come to an end.
Socialist Planning in Western Eyes
Understanding of the difficulties of central planning was slow to emerge. In the midthirties, while the Russian industrialization drive was at full tilt, few voices were raised about its problems. Among those few were Ludwig von Mises, an articulate and exceedingly argumentative free-market economist, and Friedrich Hayek, of much more contemplative temperament, later to be awarded a Nobel Prize for his work in monetary theory. Together, Mises and Hayek launched an attack on the feasibility of socialism that seemed at the time unconvincing in its argument as to the functional problems of a planned economy. Mises in particular contended that a socialist system was "impossible" because there was no way for the planners to acquire the information—"produce this, not that"—needed for a coherent economy. This information, Hayek emphasized, emerged spontaneously in a market system from the rise and fall of prices. A planning system was bound to fail precisely because it lacked such a signaling mechanism.
The Mises-Hayek argument met its most formidable counterargument in two brilliant articles by Oskar Lange, a young economist who would become the first Polish ambassador to the United States after World War II. Lange set out to show that the planners would, in fact, have precisely the same information as that which guided a market economy. The information would be revealed as inventories of goods rose and fell, signaling either that supply was greater than demand or demand greater than supply. Thus, as planners watched inventory levels, they were also learning which of their administered (i.e., state-dictated) prices were too high and which too low. It only remained, therefore, to adjust prices so that supply and demand balanced, exactly as in the marketplace.
Lange's answer was so simple and clear that many believed the Mises-Hayek argument had been demolished. In fact, we now know that their argument was all too prescient. Ironically, though, Mises and Hayek were right for a reason that they did not foresee as clearly as Lange himself. "The real danger of socialism," Lange wrote, in italics, "is that of a bureaucratization of economic life." But he took away the force of the remark by adding, without italics, "Unfortunately, we do not see how the same or even greater danger can be averted under monopolistic capitalism."
The effects of the "bureaucratization of economic life" are dramatically related in The Turning Point, a scathing attack on the realities of socialist economic planning by two Soviet economists, Nikolai Smelev and Vladimir Popov that gives examples of the planning process in actual operation. In 1982, to stimulate the production of gloves from moleskins, the Soviet government raised the price it was willing to pay for moleskins from twenty to fifty kopecks per pelt. Smelev and Popov noted:
State purchases increased, and now all the distribution centers are filled with these pelts. Industry is unable to use them all, and they often rot in warehouses before they can be processed. The Ministry of Light Industry has already requested Goskomtsen [the State Committee on Prices] twice to lower prices, but "the question has not been decided" yet. This is not surprising. Its members are too busy to decide. They have no time: besides setting prices on these pelts, they have to keep track of another 24 million prices. And how can they possibly know how much to lower the price today, so they won't have to raise it tomorrow?
This story speaks volumes about the problem of a centrally planned system. The crucial missing element is not so much "information," as Mises and Hayek argued, as it is the motivation to act on information. After all, the inventories of moleskins did tell the planners that their production was at first too low and then too high. What was missing was the willingness—better yet, the necessity—to respond to the signals of changing inventories. A capitalist firm responds to changing prices because failure to do so will cause it to lose money. A socialist ministry ignores changing inventories because bureaucrats learn that doing something is more likely to get them in trouble than doing nothing, unless doing nothing results in absolute disaster.
Absolute economic disaster has now been reached in the Soviet Union and its Eastern former satellites, and we are watching efforts to construct some form of economic structure that will no longer display the deadly symptoms of inertia and indifference that have come to be the hallmarks of socialism. It is too early to predict whether these efforts will succeed. The main obstacle to real perestroika is the impossibility of creating a working market system without a firm basis of private ownership, and it is clear that the creation of such a basis encounters the opposition of the former state bureaucracy and the hostility of ordinary people who have long been trained to be suspicious of the pursuit of wealth. In the face of such uncertainties, all predictions are foolhardy save one: no quick or easy transition from socialism to some form of no socialism is possible. Transformations of such magnitude are historic convulsions, not mere changes in policy. Their completion must be measured in decades or generations, not years.
About the Author
Robert Heilbroner is the Norman Thomas Professor of Economics (emeritus) at the New School for Social Research. He is the author of the best-seller The Worldly Philosophers.
Comparative Systems Questions
1) Compare and contrast Capitalism versus Socialism?
2) You studied the economics of the market system and that in the market we always find equilibrium. Can socialist planners make correct choices on product or service prices to reach equilibrium for over thousands of product or if they don’t do surpluses and shortages result through incorrect pricing policies?
3) By examining #2, in what way would you suggest that socialism if not balanced with some capitalist features could become in-efficient?
4) So why have so many Socialist countries opted to move away from most of their socialist leanings towards a more mixed Socialist Capitalist variety?
5) The USSR had more of a centralized administration while China because of it huge population has developed into a more decentralized organization. After listening to the news on TV or read the paper, which of the two economies: centralized or decentralized has seemed to be able to move quicker towards a more capitalist economy and why?
B. International Economics
Few subjects in economics have caused so much confusion—and so much groundless fear—in the past four hundred years as the thought that a country might have a deficit in its balance of payments. This fear is groundless for two reasons: (1) there never is a deficit, and (2) it wouldn't necessarily hurt if there were.
The balance of payments accounts of a country record the payments and receipts of the residents of the country in their transactions with residents of other countries. If all transactions are included, the payments and receipts of each country are, and must be, equal. Any apparent inequality simply leaves one country acquiring assets in the others. For example, if Americans buy automobiles from Japan, and have no other transactions with Japan, the Japanese must end up holding dollars, which they may hold in the form of bank deposits in the United States or in some other U.S. investment. The payments of Americans to Japan for automobiles are balanced by the payments of Japanese to U.S. individuals and institutions, including banks, for the acquisition of dollar assets. Put another way, Japan sold the United States automobiles, and the United States sold Japan dollars or dollar-denominated assets such as Treasury bills and New York office buildings.
Although the totals of payments and receipts are necessarily equal, there will be inequalities—excesses of payments or receipts, called deficits or surpluses—in particular kinds of transactions. Thus, there can be a deficit or surplus in any of the following: merchandise trade (goods), services trade, foreign investment income, unilateral transfers (foreign aid), private investment, the flow of gold and money between central banks and treasuries, or any combination of these or other international transactions. The statement that a country has a deficit or surplus in its "balance of payments" could refer to a particular class of transactions just like those offered in Table 1. As table 1, shows, in 1991 the United States had a deficit in goods of $73.4 billion but a surplus in services of $45.3 billion.
TABLE 1
________________________________________
The U.S. Balance of Payments, 1991
(billion dollars;
+ is surplus of receipts, - is deficit)
________________________________________
Merchandise trade -73.4
Services +45.3
Investment income +16.4
Balance on goods, services and income
-11.7
Unilateral transfers +8.0
Balance on current account
-3.7
Nonofficial capital* -20.5
Official reserve assets +24.2
Balance on capital account
+3.7
Total balance
0
* Includes statistical discrepancy.
SOURCE: U.S. Department of Commerce, Survey of Current Business.
________________________________________
Many different definitions of the balance of payments deficit or surplus have been used in the past. Each definition has different implications and purposes. Until about 1973 attention was focused on a definition of the balance of payments intended to measure a country's ability to meet its obligation to exchange its currency for other currencies or for gold at fixed exchange rates. To meet this obligation, countries could maintain a stock of official reserves, in the form of gold or foreign currencies that could be used to support their own currencies. A decline in this stock was considered an important balance of payments deficit because it threatened the ability of the country to meet its obligations. But that particular kind of deficit, by itself, was never a good indication of the country's financial position. The reason is that it ignored the likelihood that the country would be called upon to meet its obligation, and the willingness of foreign or international monetary institutions to provide support.
Interest in official reserve positions as a measure of balance of payments greatly diminished after 1973 as the major countries gave up their commitment to convert their currencies at fixed exchange rates. This reduced the need for reserves and lessened concern about changes in the size of reserves. Since 1973, discussions of "the" balance of payments deficit or surplus usually refer to what is called the current account. This account contains trade in goods and services, investment income earned abroad, and unilateral transfers. It excludes the capital account, which includes the acquisition or sale of securities or other property.
Because the current account and the capital account add up to the total account, which is necessarily balanced, a deficit in the current account is always accompanied by an equal surplus in the capital account, and vice versa. A deficit or surplus in the current account cannot be explained or evaluated without simultaneous explanation and evaluation of an equal surplus or deficit in the capital account.
A country is more likely to have a deficit in its current account the higher its price level, the higher its gross national product, the higher its interest rates, the lower its barriers to imports, and the more attractive its investment opportunities—all compared with conditions in other countries—and the higher its exchange rate. The effects of a change in one of these factors upon the current account balance cannot be predicted without considering the effect on the other causal factors. For example, if the U.S. government increases tariffs, Americans will buy fewer imports, thus reducing the current account deficit. But economic theory indicates that this reduction will occur only if one of the other factors changes to bring about a decrease in the capital account surplus. If none of these other factors changes, the reduced imports from the tariff increase will cause a decline in the demand for foreign currency (yen, deutsche marks, etc.) which in turn will raise the value of the U.S. dollar. The increase in the value of the dollar will make U.S. exports more expensive and imports cheaper, offsetting the effect of the tariff increase. The net result is that the tariff increase brings no change in the current account balance.
Contrary to the general perception, the existence of a current account deficit is not, in itself, a sign of bad economic policy or of bad economic conditions. If the United States has a current account deficit, all it means is that the United States is importing capital. And importing capital is no more unnatural or dangerous than importing coffee. The deficit is a response to conditions in the country. It may be a response to excessive inflation, to low productivity, or to inadequate saving. It may just as easily occur because investments in the United States are secure and profitable. Furthermore, the conditions to which the deficit responds may be good or bad and may be the results of good or bad policy, but if there is a problem, it is in the underlying conditions and not in the deficit per se.
During the eighties there was a great deal of concern about the shift of the U.S. current account balance from a surplus of $8 billion in 1981 to a deficit of $147 billion in 1987. This shift was accompanied by an increase of about the same amount in the U.S. deficit in goods. A common claim was that this shift in the international position was causing a loss of employment in the United States. But that was not true. In fact, between 1981 and 1987, the number of people employed rose by over 12 million, and employment as a percent of population rose from 60 percent to 62.5 percent.
Anxiety was also expressed over the other side of the accounts, the inflow of foreign capital that accompanied the current account deficit. Many people feared that the United States was becoming owned by foreigners. The inflow of foreign capital did not, however, reduce the assets owned by Americans. Instead, it added to the capital within the country. In any event the amount was small relative to the U.S. capital stock. Measurement of the net amount of foreign-owned assets in the United States (the excess of foreign assets in the United States over U.S. assets abroad) is very uncertain. At the end of 1988, however, it was surely much less than 4 percent of the U.S. capital stock and possibly even zero. Later, there was fear of what would happen when the capital inflow slowed down or stopped. But after 1987 it did slow down and the economy adjusted, just as it had adjusted to the big capital inflow earlier, by a decline in the current account and trade deficits.
About the Author
Herbert Stein, who died in 1999, was a senior fellow at the American Enterprise Institute in Washington, D.C., and was on the board of contributors of The Wall Street Journal. He was chairman of the Council of Economic Advisers under Presidents Nixon and Ford.
Exchange rates between currencies have been highly unstable since the collapse of the Bretton Woods system of fixed exchange rates, which lasted from 1946 to 1973. Under the Bretton Woods system, exchange rates (e.g., the number of dollars it takes to buy a British pound or German mark) were fixed at levels determined by governments. Under the "floating" exchange rates we have had since 1973, exchange rates are determined by people buying and selling currencies in the foreign-exchange markets. The instability of floating rates has surprised and disappointed many economists and businessmen, who had not expected them to create so much uncertainty. The history of the pound sterling/U.S. dollar rate is instructive. From 1949 to 1966, that rate did not change at all. In 1967 the devaluation of the pound by 14 percent was regarded as a major economic policy decision. Since the end of fixed rates in 1973 and 1991, however, the pound, on average, either appreciated or depreciated by 14 percent every two years.
The instability of exchange rates in the seventies and eighties would not have surprised the founders of the Bretton Woods system, who had a deep distrust of financial markets. The previous experience with floating exchange rates (in the twenties) had been marked by massive instability. In an influential study of that experience, published in 1942, Norwegian economist Ragnar Nurkse argued that currency markets were subject to "destabilizing speculation," which created pointless and economically damaging fluctuations.
During the fifties and sixties, however, as stresses built on the system of fixed exchange rates, both economists and policymakers began to see exchange rate flexibility in a more favorable light. In a seminal paper in 1953, Milton Friedman argued that the fear of floating exchange rates was unwarranted. Unstable exchange rates in the twenties, he maintained, were caused by unstable policies, not by destabilizing speculation. Friedman went on to argue that profit-maximizing speculators would always tend to stabilize, not destabilize, the exchange rate. By the late sixties Friedman's view had become widely accepted within the economics profession and among many businessmen and bankers. Therefore, concern over the instability of floating exchange rates was replaced by an appreciation of the greater flexibility that floating rates would give to macroeconomic policy. The main advantage was that nations could pursue independent monetary policies and adjust easily to eliminate payments imbalances and offset changes in their international competitiveness. This change in attitude helped to prepare the way for the abandonment of fixed rates in 1973.
The instability of rates since 1973 has thus been a severe disappointment. Some of the changes in exchange rates can be attributed to differences in national inflation rates. But yearly changes in exchange rates have been much larger than can be explained by differences in inflation rates or in other variables such as different growth rates in various countries' money supplies.
Why are exchange rates so unstable? Economists have suggested two explanations. One, originally expressed in a celebrated 1976 paper by MIT economist Rudiger Dornbusch, is that even without destabilizing speculation exchange rates will be highly variable because of a phenomenon that Dornbusch labeled "over-shooting." Suppose that the United States increases its money supply. In the long run this must cause the value of the dollar to be lower; in the short run it will lead to a lower interest rate on dollar-denominated securities. But as Dornbusch pointed out, if the interest rate on dollar-denominated bonds falls below that on other assets, investors will be unwilling to hold them unless they expect the dollar to rise against other currencies in the future. How can the prospect of a long-run lower dollar and the need to offer investors a rising dollar be reconciled? The answer, Dornbusch asserted, is that the dollar must fall below its long-run value in the short run, so that it has room to rise. That is, if the U.S. money supply rises by 10 percent, which will eventually mean a 10 percent weaker dollar, the immediate impact will be a dollar depreciation of more than 10 percent—say 20 or 25 percent—"overshooting" the long-run value. The overshooting hypothesis helps explain why exchange rates are so much more unstable than inflation rates or money supplies.
In spite of the intellectual appeal of the overshooting hypothesis, many economists have returned to the idea that destabilizing speculation is the principal cause of exchange rate instability. If those who buy and sell foreign exchange are rational, then forward exchange rates—rates today for sale of dollars some months hence—should be the best predictors of future exchange rates. But a key study by the University of Chicago's Lars Hansen and Northwestern University's Robert Hodrick in 1980 found that forward exchange rates actually have no useful predictive power. Since that study many other researchers have reached the same conclusion.
At the same time, particular exchange rate fluctuations have seemed to depart clearly from any reasonable valuation. The run-up of the dollar in late 1984, for example, brought it to a level that priced U.S. industry out of many markets. The trade deficits that would have resulted could not have been sustained indefinitely, implying that the dollar would have to decline over time. Yet investors, by being willing to hold dollar-denominated bonds with only small interest premiums, were implicitly forecasting that the dollar would decline only slowly. Stephen Marris and I both pointed out that if the dollar were to decline as slowly as the market appeared to believe, growing U.S. interest payments to foreigners would outpace any decline in the trade deficit, implying an explosive and hence impossible growth in foreign debt. It was therefore apparent that the market was overvaluing the dollar. Overall, there is no evidence supporting Friedman's assumption that speculators would act in a rational, stabilizing fashion. And in several episodes Nurkse's fears of destabilizing speculation seem to ring true.
What are the effects of exchange rate instability? The effects on both the prices and volumes of goods and services in world trade have been surprisingly small. During the eighties real West German wages went from 20 percent above the U.S. level to 25 percent below, then back to 30 percent above. One might have expected this to lead to huge swings in prices and in market shares. Yet the effects, while there, were fairly mild. In particular, many firms seem to have followed a strategy of "pricing to market" (i.e., keeping the prices of their exports stable in terms of the importing country's currency). Significant examples are the prices of imported automobiles in the United States, which neither fell when the dollar rose nor increased much when it began to fall. Statistical studies, notably by Wharton economist Richard Marston, have documented the importance of pricing to market, especially among Japanese firms.
The policy implications of unstable exchange rates remain a subject of great dispute. Refreshingly, this is not the usual debate between laissez-faire economists who trust markets and distrust governments, and interventionist economists with the opposite instincts. Instead, both camps are divided, and advocates of both fixed and floating rates find themselves with unaccustomed allies. Laissez-faire economists are divided between those, like Milton Friedman, who want stable monetary growth and therefore want to leave the exchange rate alone, and those who, like Columbia University's Robert Mundell, want the discipline of fixed exchange rates and even a return to the gold standard. Interventionists are divided between those who, like Yale's James Tobin, regard exchange rate instability as a price worth paying for the freedom to pursue an activist monetary policy, and those who, like John Williamson of the Institute for International Economics, distrust financial markets too much to trust them with determining the exchange rate.
In general, sentiment among both economists and policymakers has drifted away from belief in freely floating rates. On the one hand, exchange rates among the major currencies have been more erratic than anyone expected. On the other hand, the European Monetary System, an experiment in quasi-fixed rates, has proved surprisingly durable. Taking the long view, however, attitudes about exchange rate instability have repeatedly shifted, proving ultimately as poorly grounded in fundamentals as the rates themselves.
About the Author
Paul Krugman is a professor of economics at Princeton University. In 1991 he won the American Economic Association's John Bates Clark Medal, given every two years to "that American economist under the age of 40 who is adjudged to have made a significant contribution to economic thought and knowledge." He has been a consultant to the International Monetary Fund, the World Bank, the United Nations, the Trilateral Commission, and the U.S. State Department. He was also on the staff of President Reagan's Council of Advisers. He was an adviser to Bill Clinton during the 1992 presidential campaign.
International Business Questions
1) Looking at Table 1, what is a balance of payment account trying to uncover?
2) What sort of items does the US examine as to its International transactions?
3) In discussing how Government Balances its Treasury and Government expenditure budget, how important is it that the United States examines its foreign Balance of Payments account quarterly or yearly?
4) Currencies used to be fixed but why have we moved towards flexible currencies that rise and fall over time?
5) Can an increase or decrease in the US dollar change which parts of Table 1 in the US account Balance of Payment account?
6) According to economists what do they suggest should happen to exchange rates, should exchange rates be fixed (with other countries rates), flexible (adjust daily with changes in other currencies) or should they have a semi fixed- flexible nature or (having a bit of both fixed and flexible status)?
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