Macroeconomics For Everyone c Javier D´ıaz-Gim´

enez and Gerardo Jacobs Latest Changes: September 24, 2008 E-mail address: [email protected] Very Preliminary Version. Please do not quote

Chapter 0

THE PERFECT ECONOMY ´ La Muerte (o su alusi´ on) hace preciosos y pat´eticos a los hombres. Estos se conmueven por su condici´ on de fantasmas; cada acto que ejecutan puede ser el u ´ltimo; no hay rostro que no est´e por desdibujarse como el rostro de un sue˜ no. Todo, entre los mortales, tiene el valor de lo irrecuperable y de lo azaroso. Entre los Inmortales, en cambio, cada acto (y cada pensamiento) es el eco de otros que en el pasado lo antecedieron, sin principio visible, o el fiel presagio de otros que en el futuro lo repetir´ an hasta el v´ertigo. No hay cosa que no est´e como perdida entre infatigables espejos. Nada puede ocurrir una sola vez, nada es preciosamente precario. Lo eleg´ıaco, lo grave, lo ceremonial, no rigen para los Inmortales. Homero y yo nos separamos en las puertas de T´ anger: Creo que no nos dijimos adi´os. J. L. Borges – El Inmortal

Contents 0.0. 0.1. 0.2. 0.3. 0.4. 0.5. 0.6. 0.7. 0.8.

Introduction Economists or Fortune-tellers? The Perfect Economy Economic Growth Full Employment Stable Prices Reasonable Inequalities Economic Policy Two Presents

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0.0

INTRODUCTION

The aim of the following chapters is to help us understand how individual economies and the global economy as a whole operate and how they are managed. One way to begin to think of an economy is to look at it as if it were a large company or, better yet, as if it were a unit comprised of many companies. We must understand the word Company in the broadest and most abstract sense of “project”, be it individual or collective. All of these projects are carried out in an economic environment and are subject to specific norms. The norms determine property rights, federal incentives, define opportunities, and in general, configure rules of the game. Macro Economy is the systematic study of this economic environment. We macro economists study disaggregated consequences of all the economic decisions that are made by individual companies. We also study how the norms in economic policies conditions these decisions. In other words, in the following pages we are going to study how Spain Inc. —or if you prefer the Global Economy Inc. operates and how it is managed. We are also going to see how the norms and the ensuing economic policies condition the possibilities of the people and organizations established in their territory. Although we agree with Krugman (1996) who said, “a country is not a company” due to its greater degree of complexity and because countries are closed systems and we feel it would be dangerous to mix up the two concepts. We are also going to learn how closed systems function. The global economy is a closed system because everything is determined endogenously. In closed systems intervention may have unforeseen consequences. A very very common example of these consequences is that the butterfly flutters its wings in Iceland and inadvertently triggers a typhoon of the South Pacific. Getting a better grasp on a closed system is critical because they have their own special logic different from that which we use to understand and make decisions in open systems, as are companies, be they individual or collective in nature and regardless of their size or complexity. To decide what I am going to do for the rest of the evening, or the mid term strategy of a company, all I have to take into account are the consequences of these decisions on my own project. On the other hand, if the Government decides to negotiate with truck drivers who want to apply higher rates due to the soaring gas prices they have to take into account many other aspects in addition to studying the direct consequences of their agreement with the truck drivers. For example, they have to realize that other groups were also affected by the rising prices that want to modify their own situation, they have to consider energy policies of the whole country and maybe even the gas emission limitations including in the Kyoto Treaty. 0.1

ECONOMISTS OR FORTUNE-TELLERS?

One of the main missions for economists is to correctly answer questions that many times are extremely complex and urgent that we are asked by politicians and business people. Before beginning to describe how we fulfill this mission, quite often virtually impossible, it would be a good idea to state one clear fact: economists are experts in economy, but we are not fortune tellers. And before

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some of my colleagues are offended, let me repeat it one more time in first person, the authors of this essay do not have the slightest idea what is going to happen tomorrow, or to be more concise, we know exactly the same about the future as the taxi driver, the cyclist, the labor lawyer, or even Madonna. Collectively, the authors of this book have been studying economy for more than sixty years. We have learned quite a lot yet, nobody, ever, has ever taught us how to use a crystal ball, nor how to read tea leaves. It may seem lamentable but that’s way it is. We have studied growth and economic cycling, unemployment, inflation, fiscal policies, monetary policies, and all types of mathematics. But we have not devoted a single minute to studying futurology. Obviously, the fact that we are economists does give us a certain advantage over certain professions but we are completely convinced that there is not a single reliable fortune teller out there. And to prove it, let’s look at the following question. Exercise 0.0: Let’s suppose that an expert new the winning numbers that were going to win Friday’s lottery. If the first prize were 5 million Euros, how much would this information be worth? a. approximately 5 million Euros b. much less c. much more To answer this question, we have to look at it from both angles. If we suppose that the buyers really believe experts information is reliable, they would be willing to pay a maximum of 5 million Euros for the prize, although in most cases it would be somewhat less to cover the associated cost, including bureaucratic expenses and taxes. Yet, in an extreme case, they maybe were willing to pay more. A drug dealer who needs to launder money may be willing to pay considerably more than the 5 million Euros for the winning ticket. But, in any case, buyers will be willing to pay approximately the value of the lottery ticket prize. However, the other side of the coin, the seller’s perspective is much more interesting. Let’s assume I am the expert, and my information is 100% reliable. In that case, why would I sell the ticket for anything less than the full amount of the prize? There are only two possible answers to this question. a.) because I am stupid or b.) because in all reality the information is not 100% reliable, so expected value is much less. The first alternative is hardly interesting; you can expect almost anything of idiots and fools. Besides that, we economists have specialized in studying the behavior of rational and prudent agents so once the first answer has been discarded we are left with the second one: the information the supposed expert is selling us for more or less money is so unreliable that any amount that we pay for it is its real value. So this economic example proves that in reality, there are not any reliable fortune tellers out in the world. And if there were any, we could never do business with them because they would charge us the real value of their information. The difficulty in predicting the behavior of economic variables may also be justified from a statistical approach. The technical details are relatively complex and if any of our readers are truly interested in the field of economic forecasting and the impact of unlikely events, we recommend they read the writer Taleb (2008) which also has an extensive technical bibliography. The essence of the statistical argument is that it proves that many economic variables that do not fall in into a bell shaped curve and illustrates how difficult it is to predict behavior of this type of variables by using standard statistical techniques. To understand the difference between bell shaped spread and

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non-bell shaped ones in there relation with the theory samples let’s look at the following example: Exercise 0.1: Let’s suppose that we want to calculate the average height of the human being. We are going to do it by using a random sample of one thousand people. We measure them carefully, and calculate that the average height is 5 feet 10”. Now we look and look and finally find the tallest human being on earth and we add him to our sample. Let’s imagine that this giant is 9 feet tall. How much would that change the average height of that sample? The answer to the prior exercise is that the average would increase 1/16 of an inch, in other words, practically nothing. The increase is so tiny because the height of human beings falls into a bell shaped curve and in those cases the probability of extreme contributions diminishes very quickly the farther we are away from the midpoint. This characteristic enables us to estimate very accurately features of a universe by using very small samples. Let’s now use the same random sample to estimate the human being’s average wealth. Let’s exaggerate a lot and give our sample the average wealth of US households in 1998; 288,000 dollars, according to the survey of consumer finances. Let us now find the richest man on earth and add him to our sample. Let’s imagine it is Bill Gates. According to Fortune Magazine, his net worth is approximately 60,000 million dollars. If we now calculate the average wealth of our broadened sample we will find we have gone from 288,000 dollars to the amazing figure of 60, 227,772.00 dollars. In other words, by adding one single person to our sample we have multiplied the average by 209. This happens because the distribution of wealth does not fall in the bell curve, as it does not, the probability of new findings vary far from the midpoint and is reasonably large. And so the estimations of the features of a defined population based on samples becomes very inaccurate. This statistical argument is based on cross-section data or in other words data from a large universe at a given moment in time. If we transferred this to a series of observations taken over a period of time of a non-bell curve variable, the result we would get is that the behavior of that variable in the past is hardly useful in predicting its behavior in the future. In other words, we would see that in non-bell covered worlds surprises often happen and forecasting techniques are inaccurate because forecasting errors may be substantial. This is why predicting the future of an economy is very complicated indeed. So, if we economist’s are unable to forecast the future, what can we do and how can we help business people in their decision making? Experts in economy are much more similar to experts in medicine than to fortune tellers. Both doctors and economists study the behavior of highly complex systems - the human physiology and the global economy. So, we do not expect doctors to make a guess of when we are going to catch the flu nor are they expected to forecast how long a terminal patient will survive, nor how long a common cold will last. The same reasons - the complexity of economy - make it senseless to expect economists to guess when the growth rate of the Chinese economy is going to decrease or when the Spanish economy is going to exceed 4% annual growth again. Neither doctors nor economists are able to answer these types of questions simply because we are not fortune tellers. On the other hand, in the same way that we do expect doctors to correctly diagnose diseases and for them to give us effective remedies to cure them, macro economists are

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also expected to correctly and quickly diagnose the problems that are affecting a certain economy, or the Global economy as a whole and to propose effective measures to correct these problems. 0.2

THE PERFECT ECONOMY

As we will be seeing in the following pages, being an economist does have its advantages, although life for us is not always easy. For example, when you are at a cocktail party and the person you have just met finds out how you earn a living, or when you happen to coincide with the neighbor from the fifth floor in the elevator going down stairs, it is nearly inevitable that they will ask you something like, “And how do YOU see things?” Invariably when this happens one tends to shrug his shoulders and reply, “Well, to tell you the truth, I am not very sure. . . ” You answer that way to try to describe the current economic situation with all of its nuances in a couple of words is very complicated. Besides that I had gone to that party to relax and talk about football rather than economy and I had gone into that elevator thinking about the meeting I was going to have and at that time of the morning I can hardly say anything else except a very dry “good morning” and am very far from being ready to discuss anything about economics. However, you would be amazed at how often I hear this question and how the other person is so excited and yet concerned as they are waiting for my reply, which in the end makes me answer it. And what better place to do that than in the first chapter of a text about macro economy. It is true that in the early days of August 2008, when were writing these lines, the Spanish and European economic situation was teetering to say the least. Yet, before going into further detail about the economic situation, we are going to describe how the perfect economic situation would be. This will enable us to answer the other person with a big smile and say, “Well I think things are absolutely perfect, they couldn’t be better.” For an economist, the feature that best summarizes and describes the economic situation is economic growth. Pedro Videla, well known economist and a close friend, likes to paraphrase the Beatle’s song that says “growth is all you need” and in a very free translation as being “grow and do not worry about anything else.” What has to grow is the economic activity, or more specifically the production of goods and services or if you want to be a little more technical the GDP. GDP is the most frequent manner to measure economic activity. Every country calculates it. Its’ objective is to estimate the value of the goods and services that are produced in its territory over a certain period of time. GDP is one of the concepts of macro economy and we will be looking at it very closely in Theme 2 in this book. GDP growth is the best remedy against poverty and so it is the prime indicator about the state of health of any economy. But in order for an economic situation to be perfect, growth is not enough. In addition to growth, we need to see certain qualities. In a perfect economic situation, economic growth must be substantial, sustained, and well balanced. But, perfection is very demanding. We are not going to be satisfied just with growth although Pedro Videla or the Beatles may say the opposite. When an economy is enjoying a process of substantial, sustained and well balanced growth, the next aspect that we are going to look at is how its’ labor markets are operating. In a perfect environment, essentially everyone who wishes to

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work should have a job in accordance with his/hers skills and expectations. More technically, the ideal economy should be close to reaching full employment. Growth in employment are the prime indicators of the functioning real economy, but they alone are not enough. We also have to worry about the monetary or financial aspects. In a perfect economic situation, in addition to an impeccable real sector, we would like to see reasonably stable prices, or in other words reduced and predictable rates of inflation. And that is not all. We would also expect the perfect economic situation to have reasonable economic inequalities between people and households. These inequalities have to be compatible with growth and with our own feeling of solidarity. Each and every one of these six aspects of the perfect environment deserves a very detailed remark which will be the content of the next six sections. 0.3

ECONOMIC GROWTH

0.3.1

Substantial Economic Growth

For economic growth to be substantial means that it has to be strong enough for the state of development for that specific economy. The panel on the left of Graph 0.0 gives us the real world economy GDP growth rates for the last several decades according to the International Monetary Fund. In absolute terms, the growth trend of the world economy as represented in red is between 3 and 4%. The last estimate figure is from 2007 and as of that year the data is forecasted. Based on a superficial analysis of this data, we may reach the conclusion that the world economy has grown every year without exception since 1970, that growth rates have varied greatly, and there have been evident jumps and slow downs. The last major slow down has begun in 2008. In April 2008, which is when this report was published, the IMF was projecting world economy growth rates below the trend throughout 2009 and forecasting numbers around 4% as of 2010. GRAPH 0.0: WORLD ECONOMY REAL GROWTH RATE

Exercise 0.2: Please identify the main causes of the slow downs in the world economic growth, paying close attention to the valleys as represented in blue in the two panels on the left in Graph 0.0. The middle panel in Graph 0.0 shows the real GDP per capita growth rates of the world economy which we calculate by dividing the real GDP by the world population. Over the last four decades, the growth curve of this variable has fluctuated between 2 and 3%. However, in this case, there have been negative growth rates in 1975, 1982, and 1991. This means that if we had cut the cake of world production in equal slices for all of the inhabitants of the earth, the pieces for those years would have been smaller than the years before.

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The panel on the left shows world real GDP growth starting in the second quarter 2004 and ending Q1 2008, according to The Economist. This data is based on a sample of 52 countries representing 90% of the world GDP and confirms the slowdown of the world economy that began in Q4 2007 and became more acute in Q1 2008. The first four numerical columns in Chart 0.0 contain the real GDP growth data for a grouping of 56 countries. The first column gives us the latest 12 month period growth rate that was available in August 2008 (Most of the data corresponds to Q1 2008 although some of it is from Q2). With the exception of Ireland and Denmark, the twelve month period growth rate for all of the other countries are positive. China was the fastest growing economy with a spectacular rate of 10.1%. In general, growth rates of emerging nations were up noticeably higher than those of the developed countries. The second numerical column in Chart 0.0 contains the latest annualized Quarter by Quarter growth rates. The last twelve month period growth rates have the advantage that they are affected by seasonal variations. However, when there is a change in the growth trend - when growth accelerates or slows as happened in the beginning of 2008 - the last twelve month period rates are misleading in respect to the current economic situation because they are mixing the evolution of three relatively good quarters - the last three quarters of 2007- with one bad one - Q1 2008. For example, if we look at the negative quarter by quarter growth rates we will see that in addition to Ireland and Denmark, there are six other countries: Canada, Singapore, Columbia, Iceland (with a spectacular 14% decline), New Zealand, and Portugal. In addition to this, we compare the last twelve month period rates with the quarter by quarter rates, and we see in general that the quarter by quarter rates tend to be noticeably less the last twelve month periods rates. This is another undisputed sign that we are in a slowdown or a crisis situation. From this brief analysis of the data, we have reached two basic conclusions: substantial growth is relative to the degree of development of each country and its’ recent economic history and the concept of acceleration or slowdown should be relative to the growth curve of each economy and not an arbitrary absolute value. For example, a five percent real growth rate would be clearly insufficient for China, that has been growing at 10% over the last few years, and all of us would be talking about the profound economic crisis. But if the United States had 5% growth, that would practically double its average growth rate and we would be saying that it is in an extraordinary upswing. 0.3.2

Sustained Economic Growth

In addition to registering substantial economic growth for an economic situation, to be perfect, its growth has to be sustained. Or in other words, it must be prolonged over a period of time. When growth is sustained, economies take off and become richer, many times in a very short period of time. In order to calculate how long an economy takes to duplicate its size it should divide 70 by its’ annual growth rate. For example, if China is growing at a sustained 10% growth rate it will double the size of its economy in just 7 years (70 divided 10 equals 7).

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If the world is growing at a sustained 4% growth rate it will double the size of its economy in approximately 17.5 years (70 divided 4 equals 17.5). If The Euro Zone is growing at a sustained 2% growth rate it will double the size of its economy in approximately 35 years (70 divided 2 equals 35). Graph 0.1: Real Spanish Per Capita Growth Graph 0.1 displays the economic history between 1850 and 1993. The main source of this data is P (1996), an excellent report that reconstructs the history of the Spanish economy. Beginning in 1953, P’s data is linked to the GDP data as published by C and T (1989) and later updated by P. The data represents the real GDP as related to the cost of the factors and uses a base 2 logarithmic scale. The prime advantage of using this scale is that it greatly facilitates comparisons because the distance between the potencies of two remains constant. For instance, by glancing quickly at this graph we are able to see that the real GDP per capita of the Spanish economy took 84 years to double between 1872 and 1956, and doubled again in just 12 years between 1957 and 1969 and took 21 years to double once again between 1970 and 1991. If we study this graph more carefully, the first aspect that is called to our attention in regards to recent history of the Spanish economy is the sharp drop in the per capita GDP that took place in 1868 and the consequence of the International economic crisis and the SEXENIO revolution that effected the Spanish institutions between that year and 1874 (Please see box 0.0).The recovery is relatively quick yet, growth remained stagnated to the end of the 19th Century. The next major drop in the Spanish per capita GNP took place in 1898, once again being the consequence of losing a war. In this case, the Spanish American War which ended up with Spain losing Cuba, Philippine Islands, Puerto Rico, and Guam which was the end of the overseas Spanish Empire. Spain remained neutral in World War I favoring economic growth that was halted again at the end of the War, although it did recover during the MPR dictatorship. It looked as if the Spanish economy had definitely entered what was going to be a long period of sustained growth in the twenties. Yet, once again institutional uprisings that ended with Alphonse the Thirteenth escaping from Spain and a proclamation of the Second Spanish Republic and another downturn in growth. The military revolution in 1936 and in the Spanish Civil War that followed obviously, led to another sharp drop in the real Spanish per capita GNP that fell approximately 25% between 1935 and 1938. The Spanish Civil War and what is known as the Post War Period that followed caused Spain nearly 20 years of economic growth as until 1954 the Spanish per capita GNP did not recover its’ 1936 level. Compared with the growth that took place in both prior and later decades, the halt in economics in the 1940’s is so mind boggling that it is extremely difficult to avoid doing a little bit of economic fiction and wonder what Spanish per capita GNP would be nowadays if the average growth rate from the 1920’s had been sustained? Jumping a little bit ahead we are now looking at the sustained growth in the 60’s with average growth rate of around 7%, enabling the Spanish economy to double its per Capita in a mere 13 years (1956-1969). In the late 70’s the Spanish growth halted once again due to the first worldwide oil crisis and the change in the political regime that was foreseen once the death of General Franco

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became more imminent.

Box 0.0: The Revolutionary Sexenio in Spain (1868–1874) Between 1868 and 1874 Spain underwent six years of wars, violence, and institutional changes, unprecedented in its recent history. In 1868 Generals Prim and Topete overthrew Isabella the Second, opening a constitutional period of time that was culminated in 1870 with the crowning of Amadeo the First. Two years later the third Carlista War began that took place primarily in the Basque country and in Navarre. Hardly a year later, on February 11,1873 the first Spanish Republic was proclaimed. After four presidents and 11 months of instability and violence on January 3, 1874 General Pavia en-

tered the Spanish Parliament Chambers on horseback, dissolved it and reinstalled the Dictatorial Republic, with right wing tendencies led by General Serrano. A mere eleven months later on December 29, 1874 General Martinez Campos led an uprising in Sagunto and proclaimed the return of the Borbon Monarchy under Alphonse the 12th. The result of all of these constitutional changes was economic collapse that was further aggravated by three simultaneous civil wars: The Third Carlista War, Regional Rebellions, and The Ten Year War in Cuba.

Once the Spanish political period was completed and Democracy was consolidated, Spain joined the European Common market in 1985, incorporating many of the European Institutions and initiating a new period of sustained growth that would only be temporarily by a brief crisis in 1992. And thus we come to Q2 2008 when the Spanish economy has registered Quarter by Quarter growth rate of only 0.1%. This rather quick review of 150 years of the Spanish economy has helped us reach two basic conclusions: 1) A period of sustained growth leads to the greatest progress in economic development and 2) wars and institutional changes are the main obstacles in hindering growth. 0.3.3

Balanced Economic Growth

The next feature that we are looking for within the scope of a perfect economic situation is for it to be balanced. Major macro economic imbalances tend to have two causes: the national budget and the transactions of an economy with Foreign Economies.

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The Public Sector The Public Sector is the name that we macro economists use to refer to the nation and the best way to picture the Public Sector is think of it has a huge Company devoted to supplying the financing of the public and services. As is true in all companies, Public Sector financing is subject to budgetary restraints that simply remind us that public resources must equal their expenditures. G + Z + INT = T + DEF The budgetary restraints that are described in the formula above may be used to sum up the Public Sector budgets in all of the world’s economies. The Ministers of Economy present thousands of pages every year immediately after summer for parliamentary review and approval for the upcoming year’s budget, and all of this can broken down into five areas. All public sectors have to pay their employees’ salaries as well as buying daily supplies and capital. We group these expenses all together in one large category that we are going to generically call “public expenses” or simply G. The variable G in addition to public salaries includes such expenses as utilities in public buildings, healthcare material used in public hospitals and chalk used in public schools. These 4 items are examples of daily supplies. Yet, besides these, we are also including in G expenses such as highway construction or the purchase of computers for public universities that are examples of capital expenditures. All of the expenses that are included in G are characterized as being expenses that have a return, or in other words, the State receives goods in exchange for this expense. This merchandise or these goods are the services rendered by public employees and the investment that the State buys. Thus, the expenses that are part of G create demand for the services that are provided by the people or the merchandise that companies produce. The second large section of the public sector are public transfers. Transfers are the checks that the State sends out to families and companies. The Spanish State, for instance, pays retirement pensions to both retired and handicapped folks, unemployment subsidies, scholarships to researchers and students and subsidizes medicine purchases. All of these expenses are examples of public transfers and we are grouping them all together and call them Z. The prime feature of these transfers is that they are expenses that have nothing in return. The State does not receive anything in return for these expenses and transfers the decision to spend or not to spend onto the recipients of these transfers. For example, a retiree may either spend the money he receives as his pension or keep it in the bank. Only in the former case would the amount being transferred end up creating demand for companies. The third large section of the public sector is financing costs that we call INT. In the same way that any company has to issue bonds to finance its operations, the public sector does the same thing to cover the interest created by the outstanding public debt. And, as is true with any company, excess public sector debt could take us to bankruptcy. Public sector resources may be classified in two groups: its own resources, that we call T and outside resources, and that amount coincides with the public debt and we will call it DEF. Its own resources include all of the public sector’s source of income: taxes, Social Security payments, fees

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that the State charges for certain public services, fines and even the money we put into parking meters every day of our lives. When its own resources do not cover its expenses, the State issues and sells Public Debt, or Government Bonds signed by the Treasury, which is the State’s cash register. On the other hand, in the cases in which the amount of its own resources exceed its expenses, we say that the public accounts are positive and the public sector is able to reduce its debt and actually accumulate financial assets. The public sector budgets must be balanced for several reasons. Firstly, because the State is very large in respect to the rest of the economy —approximately 50% of the GDP in France, 40% in Spain and 30% in the USA — and thus the consequences of a poor job of handling this task by the public sector are potentially harmful for the rest of the economy. Secondly, is because excessive public sector debt may degenerate into a financial crisis that drags down the rest of the economy and either slows down growth or completely stops it . The sixth numeric column on Chart 0.1 shows the Public Deficit or Surplus for the 56 countries we are studying. Minus signs are used to show deficits and plus signs mean a Surplus. 31 countries are forecasting deficits in 2008 and the remaining 25 are expecting a Surplus: The largest surplus are in Saudi Arabia – 22% of its GDP —and Norway– 18% of its GDP. These 2 nations have smaller economies and their public sectors have major income from oil sales. Among the richer nations showing deficits are UK, France, Japan and the USA while Germany is predicting a surplus. The Foreign Sector The Foreign Sector is the name that we macroeconomists use to refer to the set comprised by all of the world’s economies except for the one called Domestic Sector that is our own reference economy. For example from the Spanish economy’s perspective, the Domestic Sector is Spain and the Foreign Sector is the rest of the countries on Earth. To fully grasp the importance of the Foreign Sector, firstly we have to review its accounting and we are going to do that by splitting it into 3 categories: exports, that we will call X , imports that we will call IM and Net Foreign Income that we will refer to as REN. An economy’s exports are the merchandise that the residing producers from the Domestic Sector sell to residents in the Foreign Sector. And its imports are the merchandise that the residents from the Domestic Sector buy from residing producers in the Foreign Sector. We should emphasize that the criteria that is used in accounting for the Foreign Sector is residency and not the actual place where the transaction is carried out. For instance, the expenses incurred by foreign tourists in Spain is included in the ledger as being a Spanish export although the merchandise never actually leaves the Spanish territory. In the same way, expenses incurred by Spanish residents abroad is listed in the books as being imports for the Spanish economy, even though this merchandise never came into Spain. Lastly, the Net Foreign Profit is the balance of all current transactions between residents and non-residents that are not related to trading of goods or services. For instance, money that foreign immigrants residing in Spain send home, dividends that Spanish companies operating abroad send

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back to their Mother company here in Spain and the transfers that the Spanish State receives from the EU are considered as Foreign Income . The former is entered in the books with a minus sign as it is an outgoing payment and the latter two with a plus sign as they are incoming payments. SBCC =X-IM+REN The Expression (0.1) defines the On-Going Balance of Payments that we are referring to as SBCC. This balance summarizes all of the current transactions between an economy and the rest of the World. To calculate it, we have to subtract from the value of all exports the value of the imports and then add that result to the Net Foreign Income. When an economy’s On-Going Balance of Payments is negative we say that that economy has an On-Going Balance of Payments deficit . This happens when the residents’ expenses for merchandise produced abroad is greater than the value of income from abroad –the income received for the sale of merchandise and the net income received for other concepts. And as long as a family, a company or an economy spends more then it earns the difference becomes an outstanding debt. To finance this difference they can either use their own resources that have been accumulated in the past or issue and sell bonds to residents abroad. One way to finance an On-Going Balance of Payments’ deficit with one’s own resources is to reduce the level of foreign currency reserves that have been accumulated in the past or by reducing your own treasury that is abroad. The second way of financing a deficit with your own resources is selling off part of your domestic sector equity. For instance, the foreign deficit may be financed by selling land, homes or companies to foreigners. The third way is to increase your debt abroad. The Outstanding Balance of the resident’s debt in an economy with the residents abroad is called “foreign debt”. As also happens with Public Debt, an economy’s excessive foreign debt may lead to bankruptcy and a collapsing of its growth process. So in a perfect economic situation economic growth must take place with a well-balanced foreign sector and a reasonable level of foreign debt that will diminish the risk of a financial crisis. The second and third numerical columns in Chart 0.1 lists the On-Going Balance of Payments for the group of 56 nations included in this research. Minus signs mean there is a deficit and plus signs indicate a surplus. Let’s look at the second column first that has the absolute values for the accumulated balances for the last 12 months. The first item that calls our attention is the huge deficit in the US economy 711 billion dollars and the deficits in the Spanish and UK economies —164 and 102 billion dollars — that get the Silver and Bronze medals in Deficit Olympic Games. Among the surpluses there are three major exporting nations that have strong manufacturing sectors, China, Germany and Japan –372, 269 and 215 billion dollars and two large raw material exporters, Suadi Arabia and Russia –110 and 95 billion dollars. Assuming there was no error nor omission in the reporting of this balance and if the data were referring to the same period of time for each country and if the list included every country in the World the sum total of the On-Going Balance of Payments would logically be zero. The third column tries to put the absolute balance values in perspective by expressing them as a percentage of the country’s GDP as forecasted for 2008 and that gives us an idea about how serious

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the imbalances really are. Surpluses are not a problem because it means the economy is either accumulating foreign assets or reducing its foreign debt. Among these countries we should highlight Saudi Arabia whose surplus is nearly 27% of its GDP and Singapore, Norway and Switzerland –19%, 17% and 15% respectively. All of these countries have a strong exporting sector, be it oil, manufactured goods or services. The most eye-catching deficits are those of smaller economies such as those of Iceland and the Baltic States, Greece and once again Spain, UK and the US. Despite the individual circumstances surrounding each of these countries may be very different indeed the amount of foreign debt shows that its growth process has en excessive dependence on foreign financing and are seen as being symptoms of an unbalanced growth process. 0.4

FULL EMPLOYMENT

Paid employment tends to be the mainstay of most households Thus sufficient quality job creation is another facet we expect to find in a perfect economic situation. Measuring paid employment is relatively simple as labor relations have two parties— the employer and the employee— and because the legal systems in most countries require the registering of all labor contracts and the corresponding Social Security payments are made. In any case, employment is not a problem, but rather a solution. The problem that many countries have is a lack of jobs. The lack of a job is what we call unemployment and this concept is much harder to measure than employment for two basic reasons. The first one is because unemployment is not an activity but rather a lack of activity, the unemployed is a person who does not have a paying job and unemployment is a desire as well; the unemployed would like to be employed. This means that not all of those who are not working should be considered as “unemployed” but rather only those who in addition to not having a job would like to have one. So “unemployment” is not tangible. The only way of knowing if a person is or is not really unemployed is to ask him/her. This is precisely what the Statistic Institutes are doing in practically every country. Periodically they carry out a survey over a representative universe to determine what the labor situation really is. In Spain, the survey concerning the people’s labor status is commissioned to the National Statistic Institute and is known as the “Survey regarding the Active Population” (EPA). The EPA is carried out on a quarterly basis and has been done ever since 1964 with the stated objective of gathering data about the people in the job market, classified by the Survey as being “employed” or “unemployed”, and those who are not actively in the job market, classified by the Survey as being “inactive”. The initial sample is comprised by 65,000 families that in all reality is reduced to around 60,000 who are actually interviewed monthly. So each quarter the Institute interviews approximately 180,000 people. The EPA is one of the main tasks of the Institute, devoting a large part of its resources to this task and its methodology closely follows the guidelines as defined by the International Labor Organization (ILO) and EUROSTAT. The universe included in the Spanish EPA is comprised by people over 16, the minimum working age in Spain. According to the EPA, the employed are those people who have worked in

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a paying job, either with an employer or on a free-lance basis during at least one hour during that specific week – a week that is chosen at random during the quarter that has finished immediately before the survey is taken. For the EPA to classify a person as being unemployed, in addition to not having been employed during the reference week he/she must also meet the following two criteria: have actively been seeking work during the last month before the interview and be willing to accept a job in the next 2 weeks after the interview. So, according to the EPA, the unemployed are not employed, looking for work and willing to work. Employed and unemployed are, together, classified as being active and everyone else over 16 —students, retirees, non-working housewives, the disabled and others— are classified as being inactive. The most controversial aspects of the employment survey and the ones that have been most heavily criticized are the term “looking for work” —as described by the EU in Box 0.1— and the exact meaning of “willingness to work” when there is no reference to the salary nor the characteristics of this potential job. Box 0.1 The Active Methods of Job Seeking in the European Union According to the Regulation 1897/2000 from the European Commission, the active methods of job seeking are as follows: - Be in contact with the Public Job Center with the objective of finding a job, regardless of who has taken the initiative (renewal of the registration for purely administrative reasons is not considered to be active seeking) - Be in contact with a Private Job Center (a Staffing agency, a company specialized in hirings, etc. ) with the objective of finding a job. - Send an application directly to a potential employer - Ask around among friends and/or trade union, etc. - Place an ad or respond to an ad in a newspaper - Study job offers - Participate in a trial, contest or interview in the scope of a hiring process. - Look for land, storefronts or material. - Carry out the tasks associated with obtaining licenses, permits or financial resources. Exercise 0.3: Lucas has had the extravagant and ridiculous idea to compare labor relations with sentimental relations. What answers would a person have to give the interviewer to be classified in the Sentimentally Active Survey as being “sentimentally unemployed”? The EPA uses a system that classifies everyone over 16 as being employed, unemployed, active or inactive in order to calculate 2 rates. The unemployment rate that is defined as being the percentage of “actives” that are unemployed, the activity rate that is defined as being the percentage of those over 16 who are active and the unemployment rate that is defined as being the percentage of those over 16 who are employed. The employment surveys done in other countries use similar methodology and definitions as the Spanish version.

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The last numerical column on Chart 0.1 gives the unemployment rates, country-by-country for the 56 included in this research: the first feature to be noted is that the unemployment rates for all countries is positive. In nations where economic freedom is guaranteed there will always be people who are unemployed and looking for work for multiple reasons and thus it is practically impossible to have a 0% rate of unemployment: when we macroeconomists talk about “full employment” we are really referring to an undefined unemployment rate, reasonably low that may be around 4% or 5% of the active population. Lower unemployment rates tend to indicate difficulties in the labor market and may generate upward pressure on salaries and lead to runaway inflation. So, we were surprised by the unemployment rates seen in such countries as Iceland, Thailand or Denmark that disclose registered rates below 2%. The average rate in the US and UK with deregulated labor markets and very low costs for dismissals tend to be around 5% and the Continental European model, highly protective in nature, tends to generate higher rates, normally around 7%. Among the nations listed on Chart 0.1, the labor market situation in South Africa with 23% of the active population unemployed is critical and the markets in Belgium, Colombia Spain and Turkey with rates hovering near 10% are concerning and far from those countries with an ideal economic situation. In addition to the labor surveys, in Spain and many other similar nations there are other sources for information that describe the labor market situation. The Spanish Labor and Emigration Ministry publishes data on a monthly basis to publicly announce the number of people included in the Social Security system and the Spanish National Ledger estimates on a quarterly or yearly basis the number of jobs and the number of full-time employee equivalents. In Spain, besides, the National Employment Institute has an Unemployment Register and publishes on a monthly basis the number of unemployed people who are registered there. The Spanish Unemployment Register operates as a Public Job Center. Registering there is voluntary for the unemployed, but it is mandatory in order to receive unemployment compensation and to sign a new labor contract. It is also mandatory to communicate any job openings although it is a well-known fact that many companies will carry out their recruitment process and then notify the Register about the vacancy, once the new person has actually been chosen. Graph 0.2 reflects the trend in Registered Unemployment in Spain between 2004 and 2008. It is easy to see the seasonality in this data. The number of registered unemployed normally increases in winter and decreases in summer. We can also see how critical the situation has become due to the economic slowdown in the Spanish economy in 2008. For the first time in at least the last 4 years there is an increase in registered unemployment figures due to the recession has overshadowed the normal seasonal rise in the Summer. More specifically, in June and July, 2008 the number of unemployed has risen by 300,000 people. Graph 0.2 Registered Unemployed in Spain (Source INEM)

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0.5

STABLE PRICES

The next feature that we are going to be looking at, within the scope of the economic situation, is price evolution. To describe the behavior of a set of prices with one sole indicator, what we do is to create a price index, which is nothing more than taking weighted averages of relative prices. Ever since the beginning of the 70’s when money stopped being converted into Gold or Silver, prices of nearly everything tend to rise, and more or less continually. So, price index also rise and the variation in rates of the price indexes are called inflation rates. In the perfect economic situation, the rate of inflation should be both low and predictable. Contrary to what may seem to be more logical, inflation does not systematically make us poorer as salaries tend to increase at the same rate as prices, although, at times, these raises take place at a later date and those affected may temporarily lose purchasing power. The main costs of inflation is to reduce the value, and hence public comfidence in money itself and this may lead to runaway inflation. The reduction of the value of money is in itself one more tax, a hidden one indeed and clearly regressive in nature, that is paid by all of us that use money. The Issuing Bank —The Central European Bank in the case of the Spanish economy —are the tax collectors. In nations with low inflation, let’s say below 5%, this tax is tiny but it grows as the rate of inflation increases and may end up destroying the value of money when inflation soars out of control. The costs of runaway inflation are devastating as it paralyzes trade and stops any economic growth process. The degree of tolerance regarding inflation varies greatly from one country to another. Germany, for instance, underwent the worst case of inflation in history in 1923 and the very thought of that harrowing experience has forced their authorities to set anti-inflation measures as one of their top priorities within the scope of their monetary policies. The Central European Bank, successor to the German Bundesbank, has maintained this concern actually incorporating it into their own statutes and set a mid-term goal of 2% inflation in the Eurozone. Some macroeconomists feel that this goal is too restrictive and favor monetary policies that will encourage employment and growth, even though there may be slightly higher rates of inflation that that expressed in the CEB aims. Inflation should not be confused with the changes in the relative prices that happens when a given good increases or decreases in price. For instance, if gas price go up and our salaries do not go up proportionately we are then poorer compared to gasoline as we able to buy less gasoline with our salary/work. As most of the transport services use oil derivates as their main source of energy when oil prices go up this rise is transferred to many other goods and then their prices go up, too which means we are poorer in respect to all of those goods whose prices have increased. Naturally, the price index will also rise to reflect these increases. Yet, in all reality, these price increases are not inflation in the strictest sense of the term. Inflation is not a temporary nor a permanent increase in a group of prices but rather a sustained increase in all prices. As we will see in Theme 5, inflation is not due to changes in relative prices but rather due to an excess of money. As Milton Friedman said in 1976, “inflation is always and everywhere a monetary phenomenon.” But regardless of its causes, nobody will argue that inflation

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is a major economic problem and most of us would prefer to live in economies with lower and stable rates of inflation. The third group of numeric columns in Chart 0.1 contain the rates of inflation according to the Consumer Index in our 56 countries. The highest is Venezuela with 32% and Pakistan at 22% followed by Egypt with 20%. These rates of inflation are very high and distorting those economies making trade very difficult and limiting specialization. The lowest rate of inflation were Japan that in June, 2008 had 2% followed by Holland at 2.6%. In the Eurozone the anticipated rate was 4.1% clearly above the objective as set by The Central European Bank. The rate of inflation in Spain was 5.0% as of June ’08 practically a full point above the Eurozone average. The gap, in this case between Spain and the rest of the countries in this same monetary zone, is worrisome as it leads to a lack of competitiveness for the companies from the country with the higher rate of inflation. 0.6

REASONABLE INEQUALITIES

The inequality among people has many different dimensions: income, wealth, education, marital status, age and many, many others. But when we look at the area of labor and income is when we end up talking about the rich and poor and that is where we economists come in. At times, these dimensions get mixed up. For instance, you may be rich in working income and yet poor from a net worth perspective. A trader in the futures market may be earning 100,000 euro/month, living with his Mother and gambling anyway every cent in the casino and thus he’d be rich in income and poor in net worth. But you can also be poor in working income and rich in net wealth. For example, the working income of a man who has recently sold his factory that manufactured automobile parts and then retired is poor yet his net worth makes him rich. Other dimensions of inequality are also important and cause economic inequality in the strictest sense. For example, inequality of opportunities —to education, to certain jobs, etc. —diminishes mobility and perpetuates the basic concept of inequality. And there are other more abstract dimensions of inequality, like the inequality of happiness that may be more concerning for us than economic inequality and may be part of its consequences. Most theories about inequality try to find its origin in Luck. Each individual birth is a very unlikely event. Besides, the genetic lottery determines many of our personal features and limits our possibilities. Family, religion and the country we live in are all lotteries that affect our lives and determine, to a great extent, our opportunities. If the origin of inequality is really in Luck, then markets tend to broaden this inequality and inheritance tends to perpetuate it. In marketplaces, we sellers compete against each other and in many cases the winner takes all and all others are left with much less: Let’s take the authors of Best-Seller-style novels, Olympic medal winners, the executives of the largest multinational companies. . . they are all basically the same in that they are very slightly better than the those on the next level right below them yet they earn much, much more. Genetic inheritances and

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economics perpetuate inequality. The opportunities and daily lives of Bill Gates’ kids are very different than those of a goat herder in the mountains in Burkina Faso. Mobility is another characteristic mixed into distribution that makes inequality more acceptable although it does not necessarily reduce it. Mobility deals out the Luck, as if we had re-dealt the cards or thrown the dice another time. Technically the more mobile a random variable is, the more often it will run through all of its possibilities. Or, in other words, if the wealth mobility is high, the poor will take fewer years, or fewer generations, to become rich and, looking at the rich the opposite is true, they will take fewer years or generation to become poor. Our own solidarity instinct leads us to reject excessive inequality and thus we require that in a perfect economic situation there should be a reasonable amount of inequality. Naturally there are different degrees of concern about inequality in the various countries and what tends to happen that when there is greater mobility, there is a lower degree of rejection of inequality. The measuring of economic inequality is quite complicated and costly. Many of the complications are due to, as we mentioned earlier, the fact that working income and wealth are not distributed in lines with a bell-shaped curve. This makes our choice about who should and who should not be in our universe rather complex. It is also relatively hard to obtain reliable data about income and wealth of certain people. Let’s imagine we had taken a representative sample of families from a certain economy and that we do know the income of each of them. To measure the inequality, firstly we must rank the elements in our universe by the chosen variable, which in the following example is starting from the lowest income and going upwards. Chart 0.2 Spanish Income and Wealth Distribution in 2002. If we are interested in relative inequality, we then calculate the Lorenz distribution curve, in other words, a percentage of the total income in the sample that corresponds to each group according to the way we have grouped them. For instance, the bottom, poorest 20%, the 60% in the middle and the top, richest 20%. If the spread were fair, the size of each group would coincide with the percentage of the variable , the bottom 20% would have 20% of the sample’s total income , the middle 60% would have 60% and the top, richest 20% would have 20%. The more inequality increases the lower the percentage of the total is in the hands of the bottom group and the higher it is in the hands of the wealthiest. The Gini Index integrates the gaps between the Lorenz Curve describing a certain spread and that of a fair or just distribution and sums up the inequality in one single number. The Gini Index gives a fair distribution a “zero” and the maximum Gini Index number is one. Chart 0.2 contains the Gini Index and a few points of the Lorenz Curve describing the spread of working income, income and wealth of the Spanish families. These statistics are calculated based upon data from the Financial Family Survey conducted in 2002 by the Bank of Spain. According to the Gini Index the distribution of wealth is the most unequal of the three spreads and that of income is the least unequal. But in all three cases the gap between the poor and the rich is considerable. For instance, in Spain the families that belong to the top 20% in respect to wealth are 9 times richer than those in the bottom 20%. More specifically, the richest earn 47.1% of the sample’s total income and the

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poorest only earn 5.1% of the total. In Chart 0.3, we see both the Gini Index and the Lorenz Curve regarding the distribution of wealth for 7 nations, all members of the EU, from the universe of these EU countries plus the USA. The source of the European data is the European Community Household Panel dated 1998 and the US data comes from the Survey of Consumer Finance that was also published in 1998. The methodology used in the European surveys was homogenous yet the US survey is a survey that was designed to carefully represent the top part. Despite this evident difference in methodology, the inequality is much greater in the US than in Europe. The Gini Index for wealth in the US is 0.55, Portugal is the most unequal in Europe and is 0.41 while the most equal in Europe is Sweden at 0.32. It caught our eye that in the US the top 1% earn 17.5% of the sample’s total and the average of the 7 European countries in this question is only 4.9%. It also noteworthy that that group of people are richer in Spain than in any other of the 6 European countries. In addition to quantifying the inequality in relative terms, you may also be keen on quantifying in absolute terms. One way to do this is reflected in Chart 0.4. This Chart contains the quintiles of the distribution data for Spanish working income, income and wealth whose Lorenz Curves are included in Chart 0.2. For example, the cell that is on the second line in the second column of the Chart tells us that the families that belong to the first quintile of the working income distribution earn between zero and nine thousand euro/year. The cell that is in the last line and the last column tells us the amounts of equity for the families in the upper quintile of wealth and varied between 211,000 and 287,000,000 euro. Another way to quantify inequality in absolute terms is by estimating the number of people that are living in extreme poverty. The World Bank defined “extreme poverty” as being having less than $1 USD per day as measured in real terms and in parity with its purchasing power. In Graph 0.3, we have listed these estimates. Panel A in that Graph contains the estimates in absolute terms. You may see quite clearly that since the end of World War II the number of extreme poor has actually increased among the population and this was especially true between 1930 and 1945, primarily due to the Great Depression and then World War II. However this tendency upwards was stopped between 1980 and 2000. In that period of time the number of extreme poor diminished by approximately 200,000,000 people due mainly to the increase in overall wealth in China and India. And all of this has happened during a period in which the world population has grown by nearly 1.6 billion people. Graph 0.3 Extreme Poverty: People who are living with less than 1USD /day (PPP) Panel B in Graph 0.3 shows the same data as a percentage of the World population. It is hard to accept that in 1900 70% of Humanity lived on less than 1USD/day although it is comforting to know that in 2000 the accumulated economic growth had managed to reduce this figure down to 20%. This spectacular reduction is just one more illustration of how fundamentally important economic growth really is. The evidence linking inequality and growth is inconclusive yet most authors do find a relationship between economic growth and reducing poverty. This means that in the vast majority of cases when the cake gets bigger all of its pieces, even the crumbs tend to get bigger as well.

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0.7

ECONOMIC POLICY

If we compare the economic situation of any of the 56 countries that we have studied with the “perfect economic situation” as has been described in the previous sections, we realize that they are all very far from perfection. The second question that economists tend to hear after the inevitable “How do YOU see things?” is, “Then what would YOU do to improve things?” Faced with this question, we economists tend to answer in one of two ways depending of how we view the effectiveness and consequences of economic policy interventions. The economists who defend the liberal approach propose that the solution for most problems is to define it and then just protect the property rights and let the market operate freely. The other approach that many economists favor is to defend the activist vision proposing that public authorities should intervene in the economy with a wide range of policies and economic regulations. We economists love to defend our stances by using analogies and parables. One of liberal economists’ favorite analogies is to compare the way markets function with life in nature and, more specifically, in the jungle. In the jungle, species compete for limited resources. The organisms that are able to make better usage of these resources prosper and multiply while those who fail to do so disappear. This competition generates a huge degree of biodiversity throughout the ecosystem, organisms large and small, slow and quick, some who only walk and others who can fly or climb, vertebrates and invertebrates and plants. A wide variety of species are competing for light and organic material. Life in the jungle is far from easy and certainly not relaxing. In order to survive you have to eat and not be eaten. And in order to successfully meet this goal by perpetrating its genetic information from each species forces it to carry out an on-going evolutionary process and to be adapting to its surroundings. Yet, although life in the jungle may be quite uncomfortable if we are to believe liberal economists, it seems to be fair. The rules of the game are well-defined, crying does not get you anywhere and the most competitive of the species —those that are the fittest — survive. If we replace organisms with “companies” and the ecosystem with “markets”, the analogy will be finished. Let’s temporarily accept that the free market is tough but fair. Next we will ask a liberal economist about the nearly 2.5 million people in Spain as of July, 2008 who are unemployed or about the 200,000,000 people in the World who are living on less than 1USD/day. It is almost sure that the liberal economist will admit that unemployment in a wealthy country like Spain is really a serious problem and that extreme poverty is a tragedy or a shame. If we push him a bit more to try and see if he/she has a solution beyond simply defining it and better defending property rights and letting free markets function, he/she may cough for a second, perhaps grind his/her teeth and before criticizing the proposals launched by the activists and may tell us the tale of the zebras and lions that may be below in Box 0.2. This tale is yet another analogy. Its rhetoric approach and aim is to convince us that economic policy should not intervene in markets as most of their consequences are hard to foresee and as many times the side effects caused by intervening make the current problems even worse instead of solving them.

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Box 0.2 The Tale of Zebras and the Lions It was dawn in the plains on a nice summer morning. That year there had been abundant rain and grass had grown higher than normal. The herd of zebras was just beginning to wake up. A zebra slightly more than a year old, opened her eyes and the first thing she saw was the meadow that went on and on, clear down to the horizon, as far as she could see. Zebras had no trouble finding food, all they had to do was bend over and chew. Yet the zebras were aware that these same grassy field that fed them also held mortal danger — lions ready to attack. This zebra lowered her head and began to munch away. She understood that at one moment or another during this beautiful day that was dawning she was going to have to run for her life. And if she expected to live to see another day, she was going to have to run even faster than the fastest lion. It was dawn in the plains on a nice summer morning. Not very far away from where the zebras were peacefully munching under the watch of a group of baboons, another group, this time lions, was also awakening. A lion, slightly more than a year old, opened her eyes and the first thing she saw was the meadow that went on and on clear down to the horizon, as far as she could see. The grassy field were only useful for lions as a hiding place and it was comforting to know that this year they had grown higher than normal and so it was a lot easier to sneak up on zebras without being caught that it had been in other years. This lion had not hunted anything in 3 days and was quite hungry. She yawned and smelt the air and she understood that at one moment or another during this beautiful day that was dawning she was going to have to run. And if she expected to live to see another day, she was going to have to run even faster than the slowest zebra. In order to intervene in a “tough but fair” balance in the meadow, first we have to choose which side we want to help. Who should we be helping, the Zebras or the Lions? This is nearly always a complicated question, firstly because the problem facing both the zebras and the lions are identical: to run fast. The same thing happens in economy. Everybody and every company face the same problem: survive and prosper in the market. And, secondly, because any intervention is costly and will force us to favor one group over the other. If we speed up the zebras, we will most likely end up without any lions. If we speed up the lions, we will most likely end up without any zebras and then a bit later without any lions either. Despite being quite attractive, objecting to this analogy is not very complicated, If we insist, the liberal economist will finally admit that in the very few cases in which economic policy intervening markets is justifiable, the ingenuity and stubbornness shown by both the people and the incentive system that is generated by free markets have basically annulled this intervention He/she will give us a series of examples such as the externalization or the staffing agencies that has distorted most of the regulations placed on the market. Or they may question the efficacy of tax cuts when families that are receiving these rebates simply save the money instead of spending to heat up the economy. They may even point out how the Basil Treaty has not been very effective as the banking institutions have found loop-holes and ways to get around these regulations and actually have expanded their business. In the pages that follow we will be reviewing this issue regarding economic policy and discussing these and other examples quite thoroughly as well as the proposals being brought forward by liberal economists.

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On the opposite side of the coin from the liberal economists and their perspective of economic policy, there are the activists who maintain that economic policy must intervene in markets and that their interventions are effective in reaching the desired results. Those in favor of this approach propose and defend many economic policies and market regulation. Examples of these policies are fiscal and distributive policies among which we should mention supplying public goods, taxes, social security and transfers: monetary and exchange policies that determine the rate of interest of the intervention, regulating the financial system and choosing the exchange rate system, a vast number of regulatory measures to control the job market, limiting the types of labor contracts, setting minimum salaries and costs of dismissals, forcing participation in unemployment insurance or regulating the length of workdays: and other types of interventions in market such as price controls, environmental controls and forbidding certain types of traffic and on and on and on. . . .In these next pages ,we will also be discussing the upsides of these and other proposals being brought forward by economists. In favor of market intervention. 0.8

TWO PRESENTS

There is no better way to close than to give two gifts: The first one is an executive summary of all of the economic knowledge. Literally all of the knowledge that we economists have accumulated over the last 250 years or so, ever since Adam Smith published his paper entitled “An Inquiry into the Nature and Causes of the Wealth of Nations” that many feel to be the first text about economics. It may surprise us that so much can be summed up in just 3 words: “There is No Free Lunch” These five tiny words are much more than just a simple sentence that has been chosen to get a quick smile and deserve some commentary. Economics studies how people manage scarcity. And, as Borges said and as was quoted at the beginning of this chapter, among human beings everything is scarce. The universality of scarcity is not because we have a huge appetite, nor that we are nonconformists who are unable to be satisfied with what we have or that 200 million of us are living with less than a dollar /day. Scarcity is everywhere in our lives because we are, and know we are, mortals. As our own lives have a limited length of time, each instant is irreplaceable and valuable. The scarcity of time is transferred to everything we do and everything we have and to each and every one of our decisions. It also makes lost opportunity costs pop up on all sides. The decision to write or to read this very chapter, just as an example, means we are paying a considerable cost: we have to renounce the value of doing something else, perhaps a better alternative. The richest person on Earth, — let’s say Bill Gates — and the poorest, who we will call “the last beggar” both have to pay for all of their acts with the same cost: the value of the time that it has taken them to do it. So. . . ”Nothing is free”. Not even the abstract things that at times we seem to be giving away as a gift or that others are giving to us. We economists know that we have already paid the price or that we are now paying it or we will pay it some time in the future. The second gift come from Kurt Lewin, one of the pioneers in the psychology in education and in organizations. And more than a gift, in all reality its more of an advertising jingle to promote

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the following pages: Nothing is as Practical as a Good Theory This sentence although it may seem paradoxical reminds us that the good theories tend to be useful in the practice, although at times their usefulness is not obvious at first glance. The macroeconomic theories that are developed in these pages are an approximation to the complex and ever-changing reality of the Global economy. Its practical usefulness lies in the fact that it helps us to think about the term in a closed system and in that it brings to the surface the at times unexpected consequences of the economic policies and the market regulations. They are also helpful because the proper or mistaken handling of the economic environment limits our decisions, modifies our opportunities and affect our lives and business.