Special Problems in Economics

There are myriad factors in economics that can influence fiscal health or anemia. While economists are a constantly evolving breed in search of a relevant mechanism that can help explain economic performance, there are elements that, if unaccounted for, can cause serious problems within the study of economics and, ultimately, for policy. This paper examines a few of these problems in the context of prominent domestic and international economic issues.

Keywords Currency Exchange Rates; Liberalization; Linear Modeling; Market Equilibrium; Substitution

Economics > Special Problems in Economics

Overview

The iconic economist Milton Friedman once offered his thoughts on the causes of the Great Depression of the early 20th century, pointing the finger at the government's policy responses to the economic slowdowns that led to the market collapse in 1929. Somewhat contrary to the precepts being proffered by his peer John Keynes, which called for government involvement and intervention in times of economic crisis, Friedman contended that the Depression was "produced by government mismanagement rather than by any inherent instability of the private economy" (Friedman, 2002, p. 38).

What were the forms of mismanagement to which Friedman was referring? In an op-ed piece written after his passing, colleagues Edward Nelson and Anna Schwartz asserted that Friedman was not suggesting that the government was ill advised to issue any responsive policy to the steadily declining economy. Rather, they wrote, the institutions that were established to prevent such a collapse (namely the Federal Reserve) offered solutions that were contradictory to long-term fiscal health, such as raising discount loan rates at a time when banks around the nation were closing (Nelson & Schwartz, 2007).

Similarly, a well-intentioned effort to reinvigorate the economy by installing a series of trade barriers under the Smoot-Hawley Tariff Act of 1930, thereby protecting domestic industries, caused far more harm by making international trade cost-prohibitive for foreign investors. US imports and exports suffered terribly as world trade declined nearly 66 percent over a four-year period (US Department of State, 2007).

Although some loyalists to Keynes assume that Friedman meant that government should have stayed out of formulating policy to counter the market instability of the 1920s and 1930s, in truth he was commenting on the apparent missteps of the government, not on the fact that it had intervened at all. The Depression was to many a "perfect storm": a variety of factors, both in the market and on the part of the government, combined to create a painful, dark period in international history. A large collection of unanticipated factors and conditions joined together to cause the greatest market collapse in US history, and with no control over those elements and no effective policy response on the part of the government, the Depression would take root for years.

The fact that the Fed response created more harm than good, as did Smoot-Hawley, illustrates an important point: there are myriad factors in economics that can influence fiscal health or anemia. While economists are a constantly evolving breed, in search of a relevant mechanism that can help explain economic performance, there are elements that, if unaccounted for, can cause serious problems within the study of economics and, ultimately, for policy. This paper will examine a few of these problems in the context of prominent domestic and international economic issues.

Exchanging Currencies

On September 20, 2007, an extraordinary event occurred. For the first time in over 30 years, the Canadian dollar became equal in value to the US dollar. For decades, it was considered bad fiscal policy for Canadians to take their business to their neighbor to the south, given the great disparity between the two currencies' values. Conversely, during those three decades, the US thrived on the currency gap. Americans, taking advantage of "fire sale" business deals, traveled north in droves to do business, so much so that Fortune published an article titled "Is Canada for Sale?"

When parity was announced, however, a new way of life was born. Canadians began reversing the tide, flowing south to find fire sales of their own. A 1998 Canadian law prohibits banks in that country from merging. In light of this restriction, banks had no choice but to pursue mergers with American financial institutions, moves that would almost always work to the advantage of the US party. With the development of September 2007, however, Toronto-based Dominion Bank announced its acquisition of New Jersey–based Commerce Bankcorp for $8.5 billion — saving $1 billion Canadian, since the deal was first pursued in June of 2007 (Leonard, 2007).

The flip-flop between US and Canadian dollar exchange rates was unanticipated by most, particularly in light of the long-standing inequity between the two. In fact, currency exchange is one of the most difficult areas to model and predict in the field of macroeconomics. Some modeling can be employed to analyze specifically tailored samples of currency relationships in their current states, but such data becomes less reliable when external macroeconomic variables come into the picture and as the perspective moves from the present to the future. Among the variables that can wreak havoc on currency-exchange modeling are industrial shifts, political instabilities, and countless elements that constitute and affect aggregate supply and aggregate demand. One study looks at the propensity for macroeconomic studies to seek simplicity in modeling currency exchange and concludes that overly simplistic modeling may prove inadequate. As an alternative, the authors propose employing mixed models, the foci of which take into account the variety of influences that may impact expectations formation (Uctum, 2007).

The problem that exists with regard to currency exchange is not analysis of the trends and rates at which one currency performs against another. Empirical data can paint a picture of such situations with relative accuracy. It is the forecasting of and long-term expectations for currencies that create inconsistencies and unpredictability in modeling. Linear modeling has been many economists' preferred method of analyzing currency, but the limitations on the degree to which forecasting can be done are indicative of the need for more reliable data-collection resources. One study concludes that other forms of models, such as nonlinear formulae, yield similar results to linear forecasts and, as they rely on forecast data and environmental conditions, may prove more reliable in data collection than their linear counterparts (Boero, 2002).

Market Instability

Arguably, the most difficult challenge facing an economy is not developing industries or maintaining a stable workforce, although these are indeed challenges in and of themselves; it is ensuring that the delicate balancing act between supply and demand, known as equilibrium, continues for the long term. In a free-market system, in which the myriad elements that constitute aggregate supply and demand interact, it is critical that extraneous forces do not cause a disproportionate impact on that balance, lest the market be placed at risk.

Of course, there are a plethora of these external influences, each of which can either have an immediate influence on market stability or set in motion a chain of events that will undermine a market's performance in the long term. While identifying these factors it is not necessarily difficult, predicting when and how they will impact the market is.

The implications of market instability are obvious. In the 1970s, when developing economies were already in a fragile state, a sudden spike in oil prices sent currencies into a freefall and markets all over the world into turmoil (Bleaney, 2005). Market crises such as the Mexican peso collapse of 1994, the Asian economic crisis of 1997, the continuing struggles of the markets of the former Soviet states, and the US housing market woes that sparked the 2008 global recession lend a sense of urgency to the need to predict and assess the depth of issues that can disrupt market stability.

A market's concentration (the number of viable industries within a given system) is vital to its health, but what happens when the industry or industries that make up the economy suffer adversity from extraneous factors? Ideally, a healthy market that loses the strength of one or more of its industries will be able to correct the blow by substituting a healthy industry in the place of underperforming economic sectors. Then again, here too a problem exists: how to predict when and in what capacity substitution should occur in a concentrated market in order to maintain equilibrium.

A recent study of concentrated markets and the timeliness of substitution in faltering systems revealed that equilibrium can be maintained if industries are able to quickly react and replace faltering firms. Of course, the devil remains in the details; markets are dynamic and extraordinarily complex in nature, after all. As a result, corrective measures to prevent market instability tend to be reactive, not proactive and preventative (Cetorelli, 2007).

Crisis

Each of the examples above alludes to an important point: many of the problems in the analysis and subsequent management of economic systems are addressed reactively, not proactively. Often, the most impactful issue facing these systems is a sudden shock, not a long-term trend. Shocks come in a wide variety. The sudden shutdown of a major manufacturing facility that employs a high percentage of its staff from the small town in which it is located has an immediate and unanticipated effect on the local and regional economy. If an oil-producing country replaces its US- and European Union–friendly government with an anti-Western regime in a violent coup, it can send oil prices skyward around the globe. A hurricane making its way up the Eastern Seaboard might force major airports from Miami to Boston to reroute and cancel flights, which in turn would prevent major conferences and conventions from taking place, prompting innumerable hotel room cancellations and putting a major crimp in local economies.

In truth, the natural progression from economic theory to modeling to forecasting and, finally, to economic policymaking is a cautious one, and lurking in the shadows outside of this linear process is a specter known as "the crisis." For this reason, economists, accepting of the fact that one cannot anticipate every one of the potential shocks to the system, look at how to react to crises rather than how to prevent them. In some cases, a reaction to elements that could potentially grow into a crisis may mitigate that situation before it becomes unmanageable.

One study of the Chinese economy supports this concept. Since the 1990s, China has steadily become one of the largest and most powerful economies in the world, enjoying most–favored-nation status with another top-tier trading partner (the US) and dominating mainland Asia in influence. Still, China has proven to be something of an enigma, particularly for those who still see the country as a communist power. The People's Republic of China is a nation that, every 10 to 20 years, seems to halt its progress toward economic liberalization and take a few steps back in order to enhance and underscore its Maoist roots. Hence, as Western economies have continued along the capitalist avenue, sometimes for hundreds of years, and more recently formed economies such as the former Soviet states have committed themselves to the free-market ideal as well, China's slow political transformation and propensity for strictly governing markets continue to frustrate Western trade partners.

The delay in completely opening Chinese markets without heavy trade barriers or restrictions, while a different approach to economic liberalization, is perhaps not a completely negative one. After all, many of the former countries of the Soviet Union immediately embraced the free-market concept, only to find themselves handicapped by weak currencies, homogenous industrial bases, and unprepared fiscal infrastructures. China's approach has been more conservative. As the authors of this study conclude:

Whether the Chinese policy of impeding the liberalization of its economic endeavors is a reasonable response or merely an overly conservative way of avoiding dramatic regime change is a debate for another forum. Still, that nation employed this action in the face of the near collapse of other liberalizing economies — those in the former Soviet Union — that resulted from adoption of the free-market system. The point to be made is that China's trade restrictions are a reaction to international economic turmoil and a policy response designed to avoid a potential crisis.

Conclusions

While Milton Friedman was known for his no-nonsense analysis of economic policy, economics is a field in which nothing is ever completely set in stone. A contemporary of Friedman, Paul Samuelson, once commented on the fact that although he and Friedman took similar career paths, Friedman was rarely wrong, while Samuelson frequently erred. However, Samuelson's "errors" were in fact groundbreaking, leading to the correct application of hypotheses. His work Economics: An Introductory Analysis, first published in 1948, was released in its 19th edition in 2010 and reads like a modern history of economic theory, covering the hypotheses that held water, the analytical methodologies that proved fruitful, and the ideas and proposals that failed. "I know better than anyone else does that you have to try out hypotheses that may not turn out to be true," he once said (Schneider, 2006).

Indeed, economics is not an arena that is static; it is a fluid, dynamic discipline, constantly changing and evolving. Economic analysis is therefore necessarily reactive. As Samuelson demonstrated throughout his illustrious career, errors in theory and modeling will occur throughout the life of the study of an economic system, and it is likely that the models and theories that have been long accepted by the mainstream will eventually come up short in explaining developments in local, national, and international economic systems.

This article has provided several examples of situations in which economic analysis and modeling come up short in the face of certain trends and environments. For example, in currency exchange, which is at the heart of international trade and commerce, fluctuations in rates can have enormous implications for business and cause monumental shifts in economic relationships. In the case of Canadian banks, the financial institutions north of the US border were previously in a bind. Prohibited by law from merging with one another, they could not merge with American banks either — not as a result of any regulation but simply because the exchange rate meant a probable significant loss on investment. In 2007, however, the weakened US dollar gave strength to the Canadian dollar, and Canadian business and tourism flourished south of the border.

Based on this example, it would seem to be important to seek a way to predict shifts in currency strength. Unfortunately, that ability has eluded economists under current modeling practices. The apparent problem is that the mainstream seems committed to the simplest forms of analysis, which may explain certain trends within a larger environment but does not account for other elements within that system. However, a multifaceted form of study, such as nonlinear modeling, may prove to be a more effective tool to address this ongoing problem in economics.

If currency exchange seems a vexing arena for economic analysis, a far more frustrating problem in terms of study is market stability. Furthermore, while the use of nonlinear, or at least similarly unconventional, methodologies may prove useful in addressing the issue, market equilibrium, which contains countless elements and subparts encompassing the two major elements of a free market (supply and demand), represents an extraordinarily difficult problem in terms of forecasting. Economists' approach to assessing the establishment and maintenance of equilibrium therefore tends to become reactive and responsive. The key to understanding market forces thus rests in studying the activities surrounding the equilibria of other markets as a baseline.

Equilibrium may prove daunting and require a more flexible approach. Crisis situations, however, are as challenging to address as they are to understand. Crises come in many forms, and the breadth of their influence is equally varied. The closure of a manufacturing plant in a rural area sends local unemployment rates skyward, tax receipts southward, and local economies into recession. A hurricane moving up the US Eastern Seaboard causes every major airport to delay or cancel flights, which in turn causes the cancellation of major conventions and conferences, delivers major losses to local hotels and restaurants (who anticipated an influx of guests and customers), and, of course, sends shockwaves across the country by delaying connecting flights.

The ideal aim of studying such crises is not just to predict them before they happen but also to foresee the breadth of the area they will affect. A careful analysis of the elements that could erupt into a crisis is certainly warranted. In the case of China, that analysis also entails a review of how crises played out in other countries.

In the study of the intricacies and innumerable components of the dynamic and ever-evolving field of economics, a number of problems can arise, primarily with regard to assessing complex, fluid trends and predicting significant events. In many circumstances, it seems that the best response is, as Samuelson suggests, to accept that problems will arise and adapt accordingly.

Terms & Concepts

Currency Exchange Rate: The monetary figure at which two or more individual currencies are exchanged.

Liberalization: A process in which an economic system is made open and as free as possible from government intervention or involvement.

Market Equilibrium: The state at which aggregate supply and aggregate demand reach a balance in price.

Substitution: The process by which an economic system replaces faltering industries with healthy corporate or business entities.

Bibliography

Bleaney, M. (2005). The aftermath of a currency collapse: How different are emerging markets? World Economy, 28, 79-89. Retrieved November 22, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=15645304&site=ehost-live

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Boudebbous, T., & Chichti, J. (2013). Do financial crises occur in advanced economies at regular intervals? International Journal of Economics & Finance, 5, 46-62. Retrieved November 26, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91679293&site=ehost-live

Cetorelli, N., Hirtle, B., Morgan, D., Peristiani, S. & Santos, J. (2007). Trends in financial market concentration and their implications for market stability. Economic Policy Review, 13, 33-51. Retrieved November 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25023253&site=ehost-live

Davis, E. & Schwartz, A. (2007). Who was Milton Friedman? The New York Review of Books, 54. Retrieved November 16, 2007, from http://www.nybooks.com/articles/20015

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Luo, J. & Tang, W. (2007). Capital openness and financial crises: A financial contagion model with multiple equilibria. Journal of Economic Policy Reform, 10, 283-296.

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Suggested Reading

Anand Tularam, G., & Subramanian, B. (2013). Modeling of financial crises: A critical analysis of models leading to the global financial crisis. Global Journal of Business Research, 7, 101-124. Retrieved November 26, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=82214373&site=ehost-live

Cetorelli, N., Hirtle, B., Morgan, D., Peristiani, S. & Santos, J. (2007). Trends in financial market concentration and their implications for market stability. Economic Policy Review, 13, 33-51. Retrieved November 19, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25023253&site=ehost-live

Chung, S. (2006). The out of sample forecasts of nonlinear long-memory models of the real exchange rate. International Journal of Finance and Economics, 11, 355-370. Retrieved November 22, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=22555427&site=ehost-live

Samuelson, Robert J. (2007). Our great recession obsession. Newsweek, 150, 66. Retrieved November 22, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=27406735&site=ehost-live