Saturday, April 05, 2014

Capacity Focus, 78: The "AS-AD" aggregate supply & aggregate demand macro view of the economy and the Caribbean sustainable development challenge

 Series: 78, 79, 80, 81, 82, b/g

Yes, the topic is a corny pun on "a sad" -- as in, a sad picture.

We might as well have a chuckle first, before getting down to serious and sobering matters.

Time to roll.

In March, I began to put together a "game" or simple simulation model for strategic change in the Caribbean, which -- though still very much a prototype work in progress -- is now helping me to think about how to develop a general orientation for sustainable development based change strategies with reference to development dilemmas facing us in the Caribbean:

 Boiled down, once a strategic change SD thinktank and transformation team has a critical mass of capacity, it should 
(A) first get into the new media space [blogs, YouTube Channels, Podcasts, web based mass media, Social Networks]  . . . relatively light resources demand . . . and use that to get in contact with networks of stakeholders, to gain resources. Then, a two-prong thrust: 

(B) education and linked short and long term capacity building, and 

(C) natural resources and hazards management bleeding over into the crucial tourism, industrial and agricultural sectors. Where, 

(D) digital productivity will be particularly important.
Which brings up, we need a bit of an update to the classic 1987 Bruntland definition of sustainable development:
SD: better and more fairly meeting our needs today while making such wise use of resources and so carefully husbanding the environment -- our bio- physical, socio- cultural and economic surroundings, and trends (. . . as well as shocks)  -- that our children can adequately meet their needs tomorrow.
All of this is in the context of thinking about the major environment and sustainable development domains and sectors that all have to be held in balance if we are to suceed in the long run . . . 

I cannot forget that here in Montserrat we lost a generation of development now buried under volcanic ash because planners were ignorant of/negligent towards the hazards posed by a looming volcano:

Plymouth, Montserrat's former capital, a few years ago -- the burial is even more complete now . . . (HT: Ivan Browne)

A lesson, paid for in treasure and blood.

By official count, no less than nineteen people died during these eruptions, for which the Rhys-Burris Coronor's Inquiry of the late 90's found HMG and the local Montserrat Government to have contributory negligent responsibility for the deaths of fourteen.

So, we need to keep a balanced view of the following thirty or so sectors/issues to properly manage the development of an economy . . . especially in a heavily tourism dependent region:

U/D Apr. 12: A conversation leads me to add the following needed corrective/balancing note on the common usage, "SD pillars," and the even more common use of "environment" to denote just the natural or biophysical domain (which unfortunately lends itself to the fallacy of imagining that one may split off "the environment" and treat it as an isolated matter . . . or worse, outright dismiss it):

. . . returning to the post already in progress . . . 

This then led me to reflect a bit on an aggregate view of Montserrat's post-volcano economy in light of the AS-AD macroeconomic model, which can be summarised . . . here, from a snapshot of a whiteboard sketch:

This needs a bit of explanation, in light of the "simplified" but it seems rather useful AS-AD macro-economy model (and HT Wiki for the base image):

The key concept, here, is that in individual markets (say for bread), as prices rise supply quantity rises, but demand quantity falls (people buy less), leading to equilibrium. That's the micro view.

But when we aggregate  . . . "add up" . . . to form a whole economy, other factors begin to play.

Let me therefore lay out some rough and ready thoughts, which of course a full bore economist is welcome to refine or adjust and correct . . . but I think the following is near enough for first thoughts:
1 -->  First, there is no overall economy price, so a price index based on a "typical" basket of goods has to be used, maybe the commonly seen consumer price index that tracks cost of living. Next, 

2 --> quantity demanded becomes in effect output of the economy, often summarised as gross domestic product, GDP or national income, Y. Then, 

3 --> aggregate demand acts as usual for a demand curve: the higher prices in the economy the lower is demand, other things being equal

4 --> Aggregate supply, though, becomes more complex. 

5 --> Deep in recession (think the notorious 1930's depression era . . . ) with a lot of land, labour, capital equipment and facilities as well as money and entrepreneurial talent idled and  lot of unsaleable goods sitting on shelves, a rise in AD will have little effect on price level.  Thus, if we break this up a bit, we can see how pushing government spending G can push up the economy, per the expression for National Income Y as sum of consumption C, Investment I and Government expenditure, with net exports added:
Y = C + I + G + (X - Im) Where also
Y1 = Y0 + g, the economy grows incrementally year to year by a growth factor g
(or if g is negative, shrinks; if g = 3%, the economy doubles roughly every 23 years, at g = 7%, it doubles in 10 years, the question is what goes into g and how g can be sustained . . . and as well we see that if a population is growing fast, it may outpace g, so improvements that lead to lessened mortality and disease can lead to more poor people (who would otherwise have died in childhood), yet another paradox of development. The answer to which is improved education, especially of girls; which triggers the so called demographic transition. )
We may picture this (in a somewhat simplified way, based on the circular flow of income captured in the Y = C + I + G + (X - Im) expression:

Where, a slightly more complex view of the flows would be:

6 --> But, if we boost government expenditure, G it will boost GDP in the short run [NB: cf. on multiplier effects here . . . and also ponder the "Austrian" viewpoint here], and will maybe unleash a better circulation of funds as optimism returns, leading to growth. That's where Y* kicks in . . .

7 --> Y* is the "natural capacity" of the economy, which may imply a significant natural unemployment rate for especially labour. (As in, unemployed workers, perhaps unemployable workers and their families and friends, can easily vote out governments if they think there is a "better" option. [Hence, the principle that people vote for their wallets.])

8 --> Y* may also reflect a significant level of idled capital equipment and facilities, as there is always a gale of Schumpeter's creative destruction blowing through an economy: new industries (or firms or technologies) are the source of long term growth, but older ones die as a result

9 --> In other words, an antiquated economy may LOOK depressed when actually it is stagnated and based on dying industries past their prime. So, we may misdiagnose the remedies required, as what one should do depends very much on where one is on the AS curve.

10 --> Now, if we are closing in on Y* from below, injections to boost AD . . . by Government or Donor spending or by playing with money supply or interest rates or a combination . . . may run into rising inflation.

11 --> If we push hard enough, we end up with growth becoming resistant and inflation trying to shoot up through the roof. In particular, as we are on the rising bend with resources tightening up, the famous Keynesian multipliers may fall so that injections don't have the impact they would on the shallower part of the curve. This tightening up or over-driving of the economy can be termed stagflation, or overheating the economy.  (Stagflation, classically, is also caused by supply shocks that cause AS to jump leftwards; e.g. oil price jumps such as in the 1970's and arguably again in the late 2000's.)

12 --> Worse, people now become more expectant of rising prices and adjust wage demands accordingly, potentially setting off a wage-price inflationary spiral. (Under these conditions, too, inflation seemingly takes on a life of its own, typically with strong pressure coming to bear on the monetary authorities to keep in place the growing money supply that supports higher wages and salaries . . . especially among those on the Government's payrolls, but which growth also is a key required cause for an inflation, as: sharply braking money supply growth tends to trigger recessions. [To understand this, let us not forget the root definition of inflation, one championed by Keynes himself -- too much money chasing too few goods.])

13 --> If your economy is heavily import dependent (as in the Caribbean), that puts pressure on balance of payments, thence foreign exchange reserves and the devaluation dilemma sets in. 

14 --> In the case of Jamaica, the Ja$ is now closing on 110: 1 US$, having started at US$1.20 : J$ 1 at the end of the sixties then slipping below the US$ in 1975-6, then being about 2:1 at the turn of the 80's then 5 - 7:1 across the mid 80's then by early 90's hitting 20:1, then by turn of 2000 35 - 40:1 then for some years 60:1 then 90:1 and now slipping again. Guyana's story is worse, and Trinidad is in the early stages, being shielded by having oil and natural gas.

15 --> Other territories have taken a strong stance against devaluation, but let's just say that when a Government in Barbados in the 90's cut Civil Servant salaries by was it 8%, it ran serious perils at the polls, and IIRC, lost.

16 --> So, it looks like, here and elsewhere, we face short term trouble and somehow have to invest in building up productive capacity, pushing the AS and Y* curves rightwards. That's hard, and there are no short cut answers. 

17 --> Thankfully, digital productivity is not extremely capital intensive, but it requires educational transformation. Which is inherently, however, a long-run investment in the future.
All of this sounds an awful lot like recent remarks by Eastern Caribbean Central Bank Governor Sir Dwight Venner: that in the OECS - EC$ subregion, for twenty years growth has slowed, and to restore sustainable prosperity and development the region has to shift to a GDP growth regime of 5 - 7% per year. Which of course requires development of clusters of new industries and revitalisation of existing ones, especially Tourism (and maybe agriculture?). 

As a local economist put it, investing in new rum shops, fast food joints and grocery shops etc won't do it. 

We may safely add: nor will ganja growing and cocaine smuggling.

I think the following introductory macroeconomics vids will help, vid 1:

vid 2:

(Yes, I know, I know, it's an hour to watch, and the hand writing is not the greatest. No flashy graphics and animations, save for audio and whiteboard markup in live progres. It is also very well put. About the best one hour you can spend on getting a key skeletal insight on macroeconomics that will take out a lot of the puzzles and pop a lot of myth-balloons. A great first step for going further, too. Well worth the investment to be more informed and insightful. better than an hour wasted on bold and brazen style soap operas or flittering around Facebook or running up a cell phone bill. Here is his handout page. Go, explore his site, here, too. Begin to enjoy learning!)

Back on focus, where do we go from here as a region?

First, we have to face some sad facts.
  • Our economies across the Caribbean are to a large extent outdated, stagnant and uncompetitive, ripe to be hard hit by creative destruction
  • They are being overheated by Governments under pressure  of expectations to feed an unsustainable consumption pattern, multiplied by 
  • communities full of a restless army of the unemployed, under-employed and working poor finding it hard to make a paycheck stretch to the next payday, much less put aside something as savings
  • We therefore face stagflation with a LOT of idle resources and opportunities gone or going to waste 
  • Our education systems are even more out of date than our economies and economic policies 
  • There is a youth and general culture that is hostile to education, learning and even to books 
  • This wastes a lot of brain power, further feeds street unrest, crime, high illegitimacy rates and family/personal instability
  • We are in the digital era mostly as consumers, not producers . . . and mobile, wireless digital technologies are proved to be able to accelerate street uprisings and revolutions 
  • They are also, unfortunately, powerful conduits for spreading rumours, slanders and myths, making basic critical thinking and civics education (cf. here for a starter in Ac 27) a vital but too often neglected topic
  •  Our consumption patterns are heavily import dependent, in an era where the energy market is volatile and getting more so as the Middle East and Russia get ever more unstable 
  •  We don't feed ourselves, and our food tastes/preferences are heavily import dependent
  • Agriculture is in large part a remnant sector
  •  Mining, quarrying and extraction industries by and large do not feed competitive value added industries
  • There is high corruption multiplied by high inefficiency . . . e.g. in Jamaica a cement company sitting on a mountain of raw materials and with its own dock in one of the ten largest natural harbours in the world went bankrupt (and was at one point importing cement from Thailand and rebagging it as its own)
  • And more, soberingly more
That sort of nest of mutually supportive problems is not going to vanish overnight. It's a generational challenge and the longer we take to start, the yet worse it will be, if we are lucky not to have a wave of social explosions first.

So, it is time to put fast talking politicians with dubious quick fix magic solutions out to pasture. 

Likewise, antiquated policies for the economy, for environment and development, for natural resources and hazards management, and education, welfare and development.

In a tourism-dependent region, it is utter, unspeakable folly to imagine we can sacrifice cultural and key natural heritage in the name of ill-considered economic projects, also.

Yes, tourism is probably one of the sectors that will respond fastest, but only as a first step.

We need to feed resources into building up our productive capacity, especially digital productivity and then focussed agriculture and industry, as well as high value services.

(Which of course brings me back to my long term initiative to create some web based education.)

We need capacity to build capacity first of all, and so we should be acting on that front now.

In such a dangerous situation as we face, delay may be fatal.

And, of course, back on this post, some basic understanding of macroeconomics may well go a long way towards helping build the consensus we need to begin to seriously progress beyond the failed stagflationary policies of the past and present. 

It is time for change, let it begin now, here, with us. END

PS: This slide show (from Singapore) may be helpful: