Glenn Hubbard and Tony O’Brien continue their podcast series hosting guest – Professor Mike Ryan of Western Michigan University. During the conversation, we learn about Mike’s experiences working with faculty from Western Michigan School of Business taking their courses online. He also offers his thoughts on the current trade situation as well as personal insights from a January visit to Japan.
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Supports: Econ (Chapter 9 – Comparative Advantage & the Gains from International Trade); Micro (Chapter 9): Macro (Chapter 7); Essentials: Chapter 19.
Is the Second Golden Age of Globalization Over?
In the past 150 years, international trade and international financial flows rapidly expanded during two periods that are sometimes called the Golden Ages of Globalization. The first began in 1870 and ended in 1914, when the outbreak of World War I caused a sharp reduction in international trade. The second began in 1948 with the establishment of the General Agreement on Tariffs and Trade (GATT) under which 23 countries, including the United States, agreed to reduce tariffs from the very high levels they had reached during the 1930s. Will the coronavirus pandemic end the Second Golden Age of Globalization?
The coronavirus pandemic that spread around the world during early 2020 resulted in a sharp decline in international trade as governments in many countries shut down businesses. For example, exports of goods from the United States declined by more than 20 percent during the first quarter of 2020, even though the virus only began to have a major effect on the world economy during the second half of the quarter.
The Debate over Importing Medical Supplies During a Pandemic
Some policymakers and economists were concerned that goods critical to responding to the pandemic were not being produced in the United States. For example, most pharmaceuticals sold in the United States are produced in other countries or rely on ingredients that are produced in other countries. The same is true of personal protective equipment (PPE), such as facemasks, protective clothing, and face shields. As more than 75 countries, including France, Germany, South Korea, and Brazil restricted or banned exports of medical supplies and hospital equipment, U.S.-based firms struggled to meet surging demand for these goods. Some policymakers argued that the coronavirus pandemic and fears of future pandemics meant that the United States should stop importing pharmaceuticals and PPE. They urged that the supply chains for those goods be relocated to the United States so that the entire quantity of the goods demanded by U.S. households and firms—particularly under pandemic conditions—could be produced domestically.
The G-20 is an organization of 20 large countries. At a G-20 meeting of trade ministers in March 2020, U.S. Trade Representative Robert Lightizer stated that “we are learning in this crisis that over-dependence on other countries as a source of cheap medical production has created a strategic vulnerability to our economy.” Some policymakers noted that China supplies more than 40 percent of world imports of PPE and also produces a substantial fraction of generic pharmaceuticals, including penicillin.
Some economists noted two important problems countries may encounter if they move to no longer relying on importing some or all medical supplies:
Other Threats to the World Trading System Resulting from the Pandemic
The World Trade Organization (WTO) is an international organization that replaced the GATT in 1995 and that oversees international trade agreements. WTO rules allow countries to impose tariffs on imports of goods that foreign governments have subsidized. During the pandemic, many governments, including the U.S. federal government, subsidized firms to help them survive the loss of revenue resulting from social distancing policies. If countries take advantage of the WTO rules to impose tariffs on imports produced by firms that had received subsidies from their governments, the result could further reduce international trade. In 2019, international trade had already declined from its level in 2018, partly as a result of a trade war between the United States and China.
Some countries, including the United States, suspended immigration and barred visitors from certain countries. If such restrictions remain in place after the pandemic has ended, they could impede international trade, which requires businesspeople to freely travel among countries.
What Can We Learn from the End of the First Golden Age of Globalization?
In the spring of 2020, it was unclear whether the disruptions to global trade from the pandemic were temporary or whether they indicated that a possible end to the Second Golden Age of Globalization. During the decades since the GATT began in 1948, many countries, including the United States, benefited from the reduction in tariffs and other barriers to trade in goods, as well as the elimination of many obstacles to the flow of funds and physical investments across borders. Countries were better able to pursue their comparative advantage in producing goods and services, thereby raising incomes. Developing countries, in particular, were able to use global financial markets to finance investment in real capital projects, such as factories, and gain access to current technologies through foreign direct investment. (In Chapter 9, Section 9.3, we discuss how countries gain from international trade and which groups within a country may lose increased international trade.)
In fact, the greatest beneficiaries of the Second Golden Age of Globalization were developing countries, such as South Korea, Taiwan, Singapore, China, and India. By relying on the global economic system, these countries were able to greatly increase economic growth, which lifted hundreds of millions of their citizens out of poverty. If the path these countries followed to increasing economic growth and rising incomes is disrupted by a new wave of tariffs and other restrictions on the international movement of goods and investment, those most likely to be hurt are low-income countries in sub-Saharan Africa, Latin America, and Asia where economic growth rates remain low.
What followed the end of the First Golden Age of Globalization helps us understand the potential consequences from disrupting trade. Kevin O’Rourke of University College Dublin, Alan Taylor of the University of California, Davis, Jeffrey Williamson of Harvard, and colleagues have documented the rapid increase in globalization—increasing foreign trade and investment—during the years between 1870 and 1913. As a fraction of world GDP, exports of goods increased by more than 70 percent between those years. This increase in world trade resulted from the following developments:
International investment flows also grew, with foreign-owned assets, such as bonds and factories, increasing from 7 percent of world GDP in 1870 to 20 percent of world GDP in 1914. These investment flows made it possible for entrepreneurs in many countries to borrow from foreign investors and also allowed technologies to spread from high-income countries, such as the United Kingdom and the United States, to lower income countries in Latin America and Asia.
International trade and foreign financial investment contributed to rising incomes during these years throughout most of western and northern Europe, the United States, Canada, Australia, New Zealand, Argentina, Chile, Uruguay, Japan, and South Africa. In addition, during these years millions of people were able to improve their living standards by migrating to other countries. The immigrants made themselves better off while also increasing the labor forces of the countries they settled in and, therefore, economic growth in those countries. Between 1870 and 1914, more than 25 million people immigrated to the United States. Argentina, Canada, and Australia, among other countries, also received large numbers of immigrants. Because these immigrants were, on average, more productive in the countries they arrived in than in the—usually lower-income—countries they left, immigration increased world GDP relative to what it would have been without this immigration.
If the First Golden Age of Globalization hadn’t ended with the beginning of World War I in 1914, other countries might have used international trade and foreign investment to increase economic growth and raise living standards. In fact, though, the world economy was entering a 30-year period of reduced trade and foreign investment. During the 1920s, several countries including the United States, raised tariffs, many countries left the gold standard, leading to instability in exchange rates, and the cost of ocean shipping actually rose. In the Great Depression of the 1930s, many countries, again including the United States, raised tariffs, and international trade declined sharply. By the end of World War II in 1945, many countries had imposed capital controls that made foreign investment difficult. In 1950, exports as a percentage of world GDP were 30 percent lower than they had been in 1913. Foreign assets as a percentage of world GDP collapsed by 75 percent between 1914 and 1945. They did not regain their 1914 level until 1980.
The problems in the global economy during this 30-year period led policymakers in many developing countries to conclude that relying on exports and foreign investment was not an effective strategy for increasing economic growth. Instead, policies of protectionism and import substitution became popular as countries imposed high tariffs to keep out foreign imports and capital controls to limit foreign investment. Government subsidies and tax breaks were used to encourage the establishment of import-competing firms, particularly in heavy industries such as steel and automobiles. Economists and policymakers who supported this approach argued that, having been given government aid and having been protected from foreign competition, domestic industries would flourish, allowing for rapid economic growth without a reliance on international trade. Sebastian Edwards of the University of California, Los Angeles has described the acceptance of these policies in Latin America: “By the late 1940s and early 1950s protectionist policies based on import substitution were well entrenched and constituted, by far, the dominant perspective.”
Unfortunately, these polices moved countries away from pursuing their comparative advantage. Many of the industries being supported were inefficient and produced goods at much higher costs than foreign producers. As a result, consumers in these countries had to pay higher prices for goods than did consumers in higher income countries where during these years import tariffs were being gradually reduced. Most countries pursuing policies of import substitution experienced slow economic growth in part because local firms, shielded from foreign competition, were much less efficient than firms in countries that still participated in the global economy. Countries in Latin America, in particular, didn’t turn away from a strategy of import substitution and begin to reopen their economies to international trade and foreign investment until the 1980s.
The decline in international trade and foreign investment that began in 1914 and persisted for 30 years reduced incomes in nearly every country relative to what they would have been if the First Golden Age of Globalization had continued. What began as a temporary reduction in trade and investment attributable to the effects of World War I persisted for various reasons long after the war had ended. Today, some economists and policymakers are concerned that the disruptions to the global economy from the coronavirus pandemic might also persist after the immediate effects of the pandemic have faded.
Sources: Greg Ip, “Globalization Is Down but Not Out Yet,” Wall Street Journal, April 28, 2020; Zachary Karabell, “Will the Coronavirus Bring the End of Globalization? Don’t Count on It,” Wall Street Journal, March 20, 2020; “Has Covid-19 Killed Globalisation?” Economist, May 14, 2020; King Abdullah II, “It’s Time to Return to Globalization. But This Time Let’s Do It Right,” Washington Post, April 27, 2020; Chad P. Brown, “COVID-19 Could Bring Down the Trading System,” Foreign Affairs, May/June, 2020; Antoni Estevadeordal, Brian Frantz, and Alan M. Taylor, “The Rise and Fall of World Trade, 1870-1939,” Quarterly Journal of Economics, Vol. 118, No. 2, May 2003, pp. 359-407; Kevin H. O’Rourke and Jeffrey G. Williamson, “When Did Globalization Begin?” European Review of Economic History, Vol. 6, No. 1, April 2002, pp. 23-50; Kevin H. O’Rourke, “The European Grain Invasion, 1870-1913,” Journal of Economic History, Vol. 57, No. 4, December 1997, pp. 775-801; Michael D. Bordo, Alan M. Taylor, and Jeffrey G. Williamson, eds., Globalization in Historical Perspective, Chicago: The University of Chicago Press, 2003; Sebastian Edwards, “Trade and Industrial Policy Reform in Latin America,” Nation Bureau of Economic Research Working Paper No. 4772, June 1994; U.S. Bureau of Economic Analysis; and U.S. Census Bureau.
Question:
There are both positive and normative aspects to the debate over whether the United States should become less reliant on imports of pharmaceuticals, medical devices, and personal protective equipment (PPE) by taking steps to relocate production of these goods to the United States.
For Economics Instructors that would like the approved answers to the above questions, please email Christopher DeJohn from Pearson at christopher.dejohn@pearson.com and list your Institution and Course Number.
Glenn Hubbard and Tony O’Brien continue their podcast series hosting guest – Jonathan Meer, Professor of Economics from Texas A&M University as well as the Director of the Private Enterprise Research Center at Texas A&M. During the conversation, we learn about Jonathan’s teaching over 3,500 students annually in a large online Principles of Microeconomics lecture course. He discusses how his usual online teaching absolutely helped his transition when Texas A&M closed for the semester. He also talks about the state of Higher Education, non-profit giving, as well as some challenges nonprofits face in these uncertain times.
Some notes from this Podcast if you’d like more information:
1. Link to Jonathan Meer’s Youtube video on setting up an online course:
2. Link to Jonathan’s website page providing links to his research papers on altruism and charitable giving: http://people.tamu.edu/~jmeer/research.html
3. Nontechnical summary of Jonathan’s research with Harvey Rosen on charitable giving: https://www.nber.org/reporter/2018number1/rosen.html
4. Please refer to the Apply the Concept feature from Chapter 2 of Hubbard and O’Brien Economics, 7/E, on the use of market mechanisms to allocate food at the Feeding America charity (for your convenience, we hope to post this shortly so check back).
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Glenn Hubbard and Tony O’Brien continue their podcast series with a first – hosing a guest – Penn State Economics Professor, James Tierney. We learn about the transition James had from an early return from spring break to now teaching hundreds of students exclusively online in response to the pandemic. Glenn and Tony also discuss with James the struggles of the housing market in a small college town like State College, PA. We also learn the reasons behind James becoming the founder of an adult Improv company in the State College-area and the impact it had on his teaching. Please listen and share!
Glenn Hubbard and Tony O’Brien continue their podcast series by spending just under 15 minutes discussing why it was so difficult for economists to see this pandemic and the associated economic downturn coming. Just as scientists lacked the indicators to see the pandemic coming, economists also didn’t have the tools available to see where the economy was headed even though some early signs were present. Please listen and SHARE with your students.
Glenn Hubbard and Tony O’Brien continued their podcast series by spending about 15 minutes discussing the impact of the Pandemic on the Mom and Pop Businesses across the country. Much of the stimulus package has been developed to save small business but might it be too late or just not enough? Please listen and SHARE with your students.
Supports: Econ (Chapter 19) & Micro (Chapter 9): Unemployment and Inflation; Essentials: Chapter 13.
Apply the Concept: The Double-Edged Sword of Unemployment Insurance
Here’s the key point: Unemployment insurance payments during the pandemic cushioned worker income losses but made layoffs more likely and made some workers reluctant to return to work.
When workers lose their jobs, they are usually eligible for unemployment insurance payments. State governments are responsible for funding the payments, although the federal government provides guidelines states must meet and contributes funds to pay for administering the program. As the following figure shows, the U.S. experienced an extraordinary surge in weekly unemployment insurance claims during April 2020. The increase in claims was much greater than occurred at any point during the Great Recession of 2007-2009, which was the most severe recession the U.S. economy had experienced since the Great Depression of the 1930s.
The spike in people losing their jobs and applying for unemployment insurance was primarily due to many mayors and governors ordering the closure of nonessential businesses to fight the spread of the Covid-19 disease caused by the coronavirus. Unemployment insurance payments vary across states but typically last for 26 weeks and are intended to replace about 50 percent of a worker’s wage, subject to a cap. In 2020, Congress and President Donald Trump enacted the Coronavirus Aid, Relief, and Economic Security (CARES) Act to provide funds to support firms and businesses suffering from the effects of the coronavirus pandemic. Included in the act was a provision to increase the normal state unemployment insurance payment by $600 per week for up to four months.
Congress and President Franklin Roosevelt created the U.S. unemployment insurance system during the Great Depression as part of the Social Security Act of 1935. The first payments were made in 1939. Congress has had two main goals in establishing and maintaining a system of unemployment insurance: (1) To provide the means for workers who have lost their jobs to continue to buy food, clothing, and other necessities; and (2) to help support the level of total spending in the economy to avoid making recessions worse. From the beginning, some members of Congress and some state legislators were concerned that payments to the unemployed would reduce the recipients’ incentive to quickly find a new job. In establishing the program in the 1930s, policymakers were influenced by the experience in England where high rates of unemployment throughout most of the 1920s had resulted in many people receiving government payments—being “on the dole”—for years. In reaction, most states established 26 weeks as the length of time the unemployed could receive payments and kept the amount of money at roughly half a worker’s previous wage.
Economists believe that any type of insurance results in moral hazard, which refers to the actions people take after they have entered into a transaction. In particular, insurance makes the event being insured against more likely. For instance, once a firm has purchased a fire insurance policy on a warehouse, it may choose not to install an expensive sprinkler system thereby increasing the chance that the warehouse will burn down. People with health insurance may visit a doctor for treatment of a cold or other minor illness, which they would not do if they lacked insurance. Similarly, moral hazard resulting from the unemployment insurance system may result in workers not accepting jobs that they would have taken in the absence of unemployment insurance.
Economists debate the extent to which the moral hazard involved in unemployment insurance has a significant effect on U.S. labor markets. Most studies indicate that unemployment does increase the length of time that workers are unemployed—the duration of spells of unemployment—thereby reducing the efficiency of the economy by decreasing the size of the labor force and the quantity of goods and services produced. But because unemployment insurance reduces the opportunity cost of searching for a job—since workers give up less income during the time they are searching—it may also result in a better fit between workers and jobs, thereby increasing worker productivity and economic efficiency. Most economists conclude that, on balance, unemployment insurance that lasts for only 26 weeks and replaces only 50 percent of previous income probably does not significantly reduce economic efficiency in the United States.
After passage of the CARES, some policymakers and economists again raised the issue of whether the unemployment insurance system provides disincentives for people to work. The additional $600 that an unemployed worker received under the CARES act increased the average unemployment insurance benefit from $378 per week to $978 per week. That income was equivalent to a wage of $24.45 per hour for a 40-hour week and was greater than the wage rate received by more than half of workers in the United States in early 2020, before the coronavirus pandemic began. As a result, some workers were reluctant to return to their previous jobs as some firms began to reopen during May.
A restaurant owner in Oregon noted that one of his cooks was receiving $376 more per week in unemployment insurance than he had earned working: “Why on earth would he want to come back to work?” The restaurant was having difficulty attracting enough workers to provide takeout and delivery services while the restaurant’s dining room was closed. As the head of the National Restaurant Association put it: “It’s not that these workers are lazy, they’re just making the best economic decision for their families.”
Some firms that were unsure whether to continue to employ workers during the period the firms were ordered closed. Retaining workers would make it easier to restart once mayors and governors had lifted restrictions on operating. But the availability of higher unemployment insurance payments made some of these firms decide to lay off workers instead. For example, according to an article in the Wall Street Journal, Macy’s chief executive stated that “the new benefits in the federal stimulus program played a role in the company’s decision to furlough 125,000 workers this past week.”
The supplementary unemployment insurance payments included in the CARES act succeeded in cushioning the income losses workers suffered from the layoffs during the pandemic, but they had also made it more likely that firms would lay off workers and made some workers more reluctant to return to work. Given that the additional $600 payments were scheduled to end after four months, it remained unclear whether the payments would have a lasting effect on the U.S. labor market.
Sources: Kurt Huffman, “Our Restaurants Can’t Reopen Until August,” Wall Street Journal, April 12, 20202; Eric Morath, “Coronavirus Relief Often Pays Workers More Than Work,” Wall Street Journal, April 28, 2020; Patrick Thomas and Chip Cutter, “Companies Cite New Government Benefits in Cutting Workers,” Wall Street Journal, April 7, 2020; Henry S. Farber and Robert G. Valletta, “Do Extended Unemployment Benefits Lengthen Unemployment Spells? Evidence from Recent Cycles in the U.S. Labor Market,” Journal of Human Resources, Vol. 50, No. 4, Fall 2015, pp. 873-909; Congressional Budget Office, “Understanding and Responding to Persistently High Unemployment,” February 2012; Daniel N. Price, “Unemployment Insurance, Then and Now, 1935-85,” Social Security Bulletin, Vol. 48, No. 10, October 1985, pp. 22-32; and Federal Reserve Bank of St. Louis.
Question: An article published in the New York Times during April 2020, quoted a policy analyst as stating that: “I would never two months ago have ever thought of advocating for 100 percent income replacement.”
Source: Ella Koeze, “The $600 Unemployment Booster Shot, State by State,” New York Times, April 23, 2020.
For Economics Instructors that would like the approved answers to the above questions, please email Christopher DeJohn from Pearson at christopher.dejohn@pearson.com and list your Institution and Course Number.
Supports: Econ (Chapter 20) & Macro (Chapter 10): Economics Growth, the Financial System, and Business Cycles; Essentials: Chapter 14.
Why Do Economists Have Trouble Predicting Recessions?
During the 2008 financial crisis,Queen Elizabeth of England visited the London School of Economics and famously asked the economists present, “Why did nobody notice it?” The queen is not alone in wondering why economists seem unable to predict when an economic crisis or financial crisis will hit.
There are three main reasons recessions are difficult for economists to predict:
Many economists believed that the doubling of housing prices between 2000 and 2006 was unsustainable. But few economists or policymakers realized that falling housing prices would lead many homeowners to default on their mortgages, particularly so-called subprime borrowers who had poor credit histories. Economists also didn’t realize these defaults would lead to falling prices of mortgage-backed and severe problems for financial firms that owned these securities. In a speech given in 2007, a few months before the Great Recession began, Federal Reserve Chair Ben Bernanke stated that: “We believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of economy or to the financial system.” Bernanke’s opinion was shared by many other economists inside and outside the Fed. Because they didn’t fully understand that, given changes in the financial system over the previous 20 years, falling housing prices would lead to a financial crisis, most economists failed to predict the financial crisis that led to the Great Recession.
Similarly, most economists and policymakers underestimated the effects of Covid-19 when the disease first appeared in China at the end of 2019. In the past 20 years, the world has seen four similar viruses:
For various reasons, none of these viruses reached the levels in the United States that required widespread quarantines or the closing of schools and other social distancing measures, although more than 12,000 people may have died of swine flu in the United States.
This experience led many economists, policymakers, firms, and investors to believe that the United States was unlikely to experience a significant economic disruption as a result of the coronavirus. From mid-December 2019 to mid-January 2020, none of the most widely followed forecasts of U.S. real GDP growth for the year 2020 indicated that a recession was likely. The real GDP forecasts from the Congressional Budget Office, the Federal Reserve’s Federal Open Market Committee, the Goldman Sachs investment bank, and 60 economists surveyed by the Wall Street Journal were all between 1.9 percent and 2.3 percent—comparable to the 2.3 percent increase in real GDP that the U.S. had experienced during 2019. The S&P 500 stock index reached a record high on February 19, 2020, despite China already having more than 50,000 cases of infection from the virus.
By mid-March, as cases of Covid-19 became common in the United States and most cities and states were announcing social distancing policies that included closing many non-essential businesses, the S&P 500 had declined by more than 30 percent and economists and policymakers all realized that the U.S. economy would be experiencing a substantial recession
That economists failed to predict the recessions of 2007-2009 and 2020 should probably not have been surprising. Economists Zidong An, João Tovar Jalles, and Prakash Loungani of the International Monetary Fund (IMF) studied how accurate economists were in forecasting recessions in 63 countries over the period from 1990 to 2014. They found that both economists in the private sector as well as the IMF’s own economists rarely succeeded in forecasting a recession before it had begun. On average during this period, real GDP declined by 2.8 percent during the first year of a recession. But in April of the year prior to the start of a recession, the average forecast from private sector economists and economists at the IMF was for an increase in real GDP of 3 percent. By October of the year prior to a recession, private economists had reduced their forecasts of real GDP for the following year on average to an increase of 2 percent and economists at the IMF had reduced their forecast to 2.5 percent but these forecasts were still well above the actual decline in real GDP of 2.8 percent.
In recent years, economists have devoted resources to forecasting how real GDP will change during the current quarter. This nowcasting, if accurate, can provide policymakers and economists information on how a recession is progressing while it is occurring. Nowcasting generally relies on identifying relationships between economic variables that have data available monthly or weekly and real GDP, which in the United States is calculated by the BEA quarterly. Because economists disagree on which data provide the most accurate forecasts of real GDP during the current quarter, their nowcasts can be strikingly different.
The following table shows seven nowcasts issued during mid-April 2020 of real GDP during the second quarter of 2020, during the recession caused by the coronavirus pandemic. The data are given as changes expressed at an annual rate, which means they should be interpreted as indicating what the change in real GDP would be if the rate at which GDP changed in that quarter were sustained for a year. (Note that the Weekly Economic Index (WEI) and the uncertainty based forecast were originally presented as the percentage change from the same quarter in the previous year and have been converted to an annual rate.) Six of the forecasts agree in predicting that real GDP would decline during the quarter at a very high rate of more than 25 percent. As a standard of comparison, before the second quarter of 2020, the largest two quarterly declines in real GDP since 1947 were the decline of 10.0 percent in the first quarter of 1958 and the decline of 8.4 percent in the fourth quarter of 2008. Even the more moderate decline predicted by the New York Fed’s Nowcast would be among the largest in the past 75 years.
Ultimately, the difficulty that macroeconomists encounter in forecasting changes in real GDP indicates the complexity of the macroeconomy. Economists have not yet succeeded in reducing this complexity to a statistical model that can reliably forecast changes in real GDP—particularly whether a recession is likely to occur.
Sources: Scott Baker, Nicholas Bloom, Steven Davis, and Stephen Terry, “Covid-Induced Economic Uncertainty,” National Bureau of Economic Research Working Paper 26983, April 2020; Zidong An, João Tovar Jalles, and Prakash Loungani, “How Well Do Economists Forecast Recessions?” IMF Working Paper, March 2018; Board of Governors of the Federal Reserve System, “Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, under Their Individual Assumptions of Projected Appropriate Monetary Policy,” federalreserve.gov, December 11, 2019; Goldman Sachs, “What’s the Outlook for the U.S. Stock Market in 2020?” January 6, 2020; “Economic Forecasting Survey,” wsj.com; Lisa Beilfuss, “Why a 50% Drop in U.S. GDP Isn’t as Bad as It Seems, barrons.com, April 14, 2020; Andrew Pierce, “The Queen Asks Why No One Saw the Credit Crunch Coming,” telegraph.com.uk, November 5, 2008; Brian Domitrovic, “The Stock Market Has Predicted Nine of the Past Five Recessions,” forbes.com, November 22, 2018; and Federal Reserve Bank of St. Louis.
Question: During the coronavirus pandemic, some people wondered why biologists seemed unable to answer many questions about the virus, including why children appeared rarely to become ill, why men were more likely than women to die from the virus, and why there was great uncertainty about whether some existing pharmaceuticals would be effective in treating the disease. Briefly discuss similarities and differences between the problem biologists faced in understanding the coronavirus and the problem economists face in predicting recessions.
For Economics Instructors that would like the approved answers to the above questions, please email Christopher DeJohn from Pearson at christopher.dejohn@pearson.com and list your Institution and Course Number.
On April 24th, Glenn Hubbard and Tony O’Brien continued their podcast series by spending about 18 minutes discussing the role of uncertainty in how quickly the economy can rebound once things open back up. A very good discussion about business cycles occurs. Instructors – Please consider sharing these podcasts with your students. A lot of URL dropping in today’s conversation so we’re providing some show notes from today’s episodes if you’d like to explore them further:
1. Weekly Economic Index: New York Fed link
FRED—St. Louis Fed link
2. Uncertainty index NBER working paper
3. Pre-World War II NBER books (full texts available):
4. Christina Romer article on the 1929 stock market crash and uncertainty: NBER working paper version
Supports: Econ & Micro: Chapter 11, Technology, Production, and Costs (Section 11.6); Chapter 13, Monopolistic Competition; Chapter 14, Oligopoly (Section 14.1); Essentials: Chapter 9, Technology, Production, and Costs; Chapter 11, Monopolistic Competition and Oligopoly
Can Mom and Pop Businesses Survive the Coronavirus Pandemic?
By early April 2020, because of the coronavirus pandemic, all 50 state governments had issued declarations of emergency and had closed schools and some or all businesses considered to be non-essential. A survey by Alexander Bartik of the University of Illinois and colleagues indicated that about 43 percent of small businesses in the Unites States had closed, causing most of their revenue to disappear. As a result, those businesses had laid off about 40 percent of their employees.
In March 2020, Congress and President Donald Trump enacted the Coronavirus Aid, Relief, and Economic Security (CARES) Act. The act included the Paycheck Protection Program (PPP), which provided loans to businesses with 500 or fewer employees to pay for up to eight weeks of payroll expenses and certain other costs. The government would forgive the loans if business owners used 75 percent of the funds for payroll expenses.
The PPP was administered by the federal Small Business Administration with the loans being made primarily by local banks. Many small businesses have trouble borrowing from banks, particularly if they lack collateral, such as owning the building they operate in, or if they don’t have a long-term relationship with a bank by having borrowed from them in the past or having maintained a business checking account with them. In a survey by the Federal Reserve conducted in 2019, before the coronavirus pandemic, 64 percent of small businesses had faced financial challenges, such as paying operating expenses or purchasing inventories, during the previous year. Of those firms, 69 percent had relied on the owner’s personal funds to meet the financial challenge.
In mid-April 2020, it was unclear whether Congress might change the PPP to make it easier for small businesses to borrow through credit unions and other lenders that are not commercial banks. News reports indicated that a significant number of small businesses had exhausted the funds their owners had available and intended to permanently close. It’s not unusual for a small firm to fail. In a typical year, even when the economy is expanding, hundreds of thousands of businesses fail (and a similar number open). But some economists and policymakers were concerned that the effects of the pandemic might lead to a permanent reduction in the number of small firms, particularly so-called “Mom and Pop businesses”—sole proprietorships that employ fewer than 20 workers. (We discuss the differences between sole proprietorships and other ways of organizing a business in Chapter 8, Section 8.1)
The pandemic posed particular challenges for these businesses. Many small retailers, such as clothing stores, shoe stores, card shops, and toy stores, had already been hurt before the pandemic as consumers shopped at online sites such as Amazon. This trend increased during the pandemic. In addition, as many consumers shifted from eating in restaurants to buying groceries from supermarkets or online, the future of some small restaurants seemed in doubt.
Even as states and cities began to allow nonessential businesses to reopen, many consumers were reluctant to return to eating in restaurants, staying in hotels, and shopping in brick-and-mortar stores in the absence of a vaccine against the coronavirus. The shift to online buying was evident during March and April 2020 when, as many small businesses were laying off workers, Amazon was hiring an additional 175,000 workers and Walmart was hiring an additional 150,000. Some public health authorities and epidemiologists were suggesting that businesses take certain steps to reassure consumers, although doing so would raise the businesses’ costs of operating. For instance, Scott Gottlieb, former Food and Drug Administration commissioner, suggested that “businesses … should look at trying to bring testing on-site at the place of employment” to reassure customers that the businesses’ workers did not have the virus. He also suggested that restaurants print their menus on paper that could be thrown away after each use and commit to more frequent disinfecting. Clearly, the revenue earned by larger businesses would be better able to cover these costs while still at least breaking even.
If the world is entering a new period with more frequent epidemics of viruses to which most people lack immunity, small businesses will be at a further disadvantage. Although Congress and the president responded to the coronavirus with the PPP program, whether they would have funds to do so during future epidemics remained unclear. As a result, it may be of increased importance that firms have the resources to finance periods of closure without having to rely on government payments, loans from banks for which they may lack the necessary collateral, or running balances on high-interest rate credit cards. The survey by Alexander Bartik and colleagues referred to earlier indicated that the average small business has $10,000 in monthly costs and less than that amount readily available to use to pay those costs. In other words, many small businesses are dependent on paying their current costs from their current revenues.
Most small business owners are resourceful enough to respond to changing conditions, but the challenges posed by the coronavirus seemed likely to reshape the structure of some industries, including restaurants, small retail stores, gyms, non-chain hotels, and small medical and dental practices. When discussing the role that barriers to entry play in determining the level of competition and the size of firms in an industry, we emphasized the role played by physical economies of scale. For instance, we noted that:
A music streaming firm has the following high fixed costs: very large server capacity, large research and development costs for its app, and the cost of the complex accounting necessary to keep track of the payments to the musicians and other copyright holders whose songs are being streamed. A large streaming firm such as Spotify has much lower average costs than would a small music streaming firm, partly because a large firm can spread its fixed costs over a much larger quantity of subscriptions sold.
We also noted that economies of scale of this type did not exist in the restaurant industry. Prior to the pandemic, it was reasonable to argue that large restaurants were typically unable to serve meals at a lower average cost than smaller restaurants and that even if smaller restaurants faced higher average costs, by differentiating the meals they served, smaller restaurants could still attract customers despite charging a higher price than larger restaurants. But if small restaurants lack the ability to finance periods of closure during epidemics and have trouble breaking even due to the higher costs of printing paper menus, testing their employees onsite, and more frequent cleaning, they may struggle to survive. Larger restaurants can spread these costs over a larger number of meals, reducing the average cost of one meal compared with smaller restaurants. As more consumers avoid restaurants and eat more frequently at home, smaller restaurants may be pushed further up their average cost curves by being able to sell only a smaller quantity of meals.
The following figure illustrates how the pandemic may affect the costs of a typical restaurant. The long-run average cost curve LRACBP shows the situation before the pandemic. The higher costs necessary to operate after the pandemic, including printing paper menus and more frequent cleaning, shifts up the long-run average cost curve to LRACAP. Before the pandemic, the average total cost curve for the small restaurant is and for the large restaurant is
. Notice that even though the large restaurant serves Q2 meals per week and the small restaurant serves Q1 meals per week, they both have the same average total cost per meal, ATC1.
Also notice that before the pandemic, serving Q1 meals per week was the minimum efficient scale for a restaurant. Minimum efficient scale is the level of output at which all economies of scale are exhausted. The pandemic increases the costs of the small restaurant from to is
, and the costs of the large restaurant from
to
. Minimum efficient scale increases to Q3, which is more meals per week than a small restaurant can sell. As a result, the average total cost of small restaurant increases to ATC3. A larger restaurant is still selling a quantity of meals that is beyond minimum efficient scale, so its average cost only rises to ATC2. With higher average costs, smaller restaurants are less able to successfully compete with larger restaurants.
Small firms in other industries are likely to face similar challenges. The result could be a contraction in the number of firms in some industries. For instance, we may see franchised firms replacing Mom and Pop businesses—more Domino’s and Pizza Hut outlets and fewer independent pizza restaurants. Although it’s too early to tell the full effects of the coronavirus pandemic on U.S. businesses, the effects are likely to be far-reaching.
Sources: Ruth Simon, “For These Companies, Stimulus Was No Solution; ‘We Decided to Cut Our Losses,’” Wall Street Journal, April 15, 2020; Amara Omeokwe, “Small-Business Funding Dispute Challenges Community Lenders,” Wall Street Journal, April 14, 2020; Alexander W. Bartik, Marianne Bertrand, Zoë B. Cullen, Edward L. Glaeser, Michael Luca, and Christopher T. Stanton, “How Are Small Businesses Adjusting to Covid-19? Early Evidence from a Survey,” National Bureua of Economic Research, Working Paper 26989, April 2020 (https://www.nber.org/papers/w26989.pdf); Board of Governors of the Federal Reserve System, 2019 Report on Employer Firms: Small Business Credit Survey, https://www.fedsmallbusiness.org/medialibrary/fedsmallbusiness/files/2019/sbcs-employer-firms-report.pdf, 2019; Norah O’Donnell And Margaret Hynds, “5 Things to Know about Reopening the Country from Dr. Scott Gottlieb,” cbsnews.com, April 14, 2020.
Question:
Sendhil Mullainathann of the University of Chicago wrote an opinion column in the New York Times describing the situation facing the owner of a small restaurant:
She has little money in cash reserve; operating margins are thin … and her savings had already been spent on expanding the cramped kitchen. What was a thriving enterprise before the pandemic will emerge—if it emerges at all—as a hobbled business, which may well fail shortly thereafter.
A) What does Mullainathan mean by the restaurant’s “operating margins are thin”? Why would we expect the operating margins of a small restaurant to be thin?
B) If this restaurant was a “thriving enterprise” before the pandemic, why might it be likely to fail after the pandemic?
For Economics Instructors that would like the approved answers to the above questions, please email Christopher DeJohn from Pearson at christopher.dejohn@pearson.com and list your Institution and Course Number.
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