Misrepresenting The Case Against Labor Unions

Yves Smith points to an article by the leftist Economic Policy Institute which supposedly refutes the supposed myth that labor unions lower productivity, a refutation that according to Smith "may be difficult for union foes to explain away".

Except that I have never heard any union foe claim that unions lower productivity. The case against unions has never involved claims about lowering productivity as far as I know. Instead, the case against unions has centered on how excessive union wage demands will make low productivity workers unemployed.

Thus while unions can be expected to lower GDP growth and even more so employment growth, there is no reason to expect them to lower productivity. Indeed, the theoretical analysis of union foes implies that unions might raise statistical productivity.

The reason is that by excluding workers with low productivity from the work force, the average productivity of those who have kept their jobs will increase. Statistical productivity is as you may know defined as the quantity of output divided by the number of workers (or the number of hours worked, but for simplicity let's ignore that other definition). Excluding low productivity workers while not employing workers with higher productivity will by definition lower employment. Since the productivity of those excluded workers were low but still positive, output will also be lowered, but since productivity was low it follows that the drop in output will be lower than the drop in employment.

And as statistical productivity was defined as the quotient between output (dividend) and employment (divisor) and as in any division, the quotient always rises if the dividend is lowered by less than the divisor, it follows that statistical productivity will increase due to union activity.

It should however be emphasized that the increase in statistical productivity does not imply any real increase in productivity for any specific workers. The workers who kept their jobs are no more productive than if the excluded workers had also kept their jobs. The average has only been increased the excluded low productivity workers are no longer counted.

U.S. Recession Worse Than Previously Estimated

Second quarter U.S. GDP growth came in roughly in line (slightly below) expectations. What was perhaps more interesting was that in the annual revision GDP was again downward revised, just as it was in previous annual revisions in 2009, 2008, 2007 and 2006.

In 2007, GDP rose by 1.9% compared to the previous estimate of 2.1%, in 2008 growth was zero compared to the previous 0.4% growth estimate and in 2009 GDP fell 2.6% compared to the previous estimate of a 2.4% contraction. The total downward revision was thus 0.8%.

National income was also revised down, but not quite as much, reflecting both an upward revision of net factor income from abroad and a downward revision of statistical discrepancy.

Given the consistent pattern that growth is always revised down in the annual revisions (for years as a whole, individual quarters can be upwardly revised or unrevised), I can safely predict that in next year's annual revision, growth for 2008 and 2009 will be revised down further.

Robert Reich, Profits & Jobs

Leftist economist and former Clinton Labor Secretary Robert Reich notes "a great decoupling of corporate profits from jobs", by which he means that corporate profits have recovered faster than employment.

He argues that there are three explanations: 1) That much of the profits come from foreign subsidiaries 2) That some of the profits come from productivity improvements 3) That corporations finds that shareholders will benefit more from dividends & share buy backs (which is essentially the same as dividends, except in its technical form).

These explanations are actually more or less correct, though Reich's interpretation of them is misleading. That is particularly true with regard to the third point.

Reich interprets the fact that corporations haven't responded to higher profits by hiring more workers this way:

"Higher corporate profits no longer lead to higher employment. We’re witnessing a great decoupling of company profits from jobs.

The next supply-side economist who tells you companies need more incentive (i.e. lower taxes) before they’ll hire is living on another planet."

But corporations don't and have never based employment decisions on current profits (at least not beyond the basic profitability that enables the company to survive), but on the expected marginal profit generated by new workers.

The current relatively low level of investments and hiring of workers illustrates that businesses often don't expect new investments to generate new profits, which in turn in fact justifies (and certainly not refutes) the supply-side argument that incentives needs to be improved.

Oil Drilling Moratorium Is A Jobs Moratorium

Investor's Business Daily points out how Obama's oil drilling moratorium is in effect a jobs moratorium in that sector. The jobs destroyed there won't be compensated by jobs elsewhere

Dying Former Axis Powers

New Eurostat population figures have now been released. While there has been marginal changes in the specific numbers, the overall picture that I analyzed last year is basically still in place, so I won't repeat that.

One striking fact is that three (Germany, Austria and Italy) out of the four countries with the lowest birth rates (Portugal, whose fascist regime was neutral during World War II being the fourth) constituted the principal World War II axis powers. In addition, Japan, the non-European former axis power has birth rates as low as the three European former axis powers.

Is this a coincidence? Probably, at least mostly. It might however also be the case that some people in those countries still feel some collective guilt (which is unjustified because the collective guilt notion is irrational,but which some people might feel anyway) over what happened in the past, and therefore don't feel like creating new people who according to the collective guilt-mentality would share that guilt.

Chocolate Speculator Nonsense

A New York Times article claims that hedge fund manager Anthony Ward has found a brilliant way of securing large profits from speculation. He buys large quantities of cocoa, something which drives up the price of cocoa, and then later sells the cocoa at a higher price.

It should be obvious that there is something seriously wrong with this trading strategy, unless some other information exists that will create high prices in the future. Assuming the reports about Ward's behavior is true, that he has purchased large quantities of cocoa and stored it, then that will certainly raise the spot price of cocoa. But unless he plans to store it indefinitely (and that seems unlikely as the cocoas will likely turn bad eventually), this won't increase prices in the future as the eventual sale of those large cocoa quantities will depress prices in the future.

Thus, there is nothing in the trading mechanism of buying now to increase the current spot price and then sell later that will guarantee a profit since the future price will be depressed by those sales. Ward's alleged bet only makes sense if he believes (as he presumably does if he has made those bets) other factors push up the price.

But what about this argument: "The fear is that Mr. Ward will become the go-to source until the annual cocoa harvest, which starts in October. With candy makers starting to stock up for the holiday season, they may be forced to pay him ever-higher prices — and cocoa has already jumped 150 percent since 2008."

This overlooks that Ward hasn't really reduced supply. All he has done is to buy the output of certain producers, thus reducing their supply, but at the same time creating a new supply source in the form of his company. This doesn't reduce supply, it only changes the identity of the suppliers from the producers (or possibly other speculators) to Ward.

Perhaps not surprisingly, Paul Krugman tries to defend his news paper's explanation:

"Does he have an incentive to hold some of that supply off the market, and in effect dump it into period 2? Yes! Suppose he owns a million candy bars: by taking one of those bars off the market until period 2, he may lose some money on that bar, but he drives up the price on the other 999,999 bars. This may give him an incentive to “dump” some of his candy into the next period, even if it looks on the surface like a money-losing proposition.

Or to put it another way, by acquiring a large share of period 1 supply, Chocfinger may have created a situation in which his marginal revenue from a current (as opposed to future) candy bar sale is quite low, making it profitable to hold bars off the market."

What Krugman describes is actually the theory of why some companies in the absence of "perfect competition" has an incentive to restrict output even though the price is higher than the marginal cost. Yet for that strategy to work output has to be permanently restricted. While holding a candy bar to a future period may increase the current price of other candy bars currently sold, it will depress the price of those future sales as total future supply will be larger.

Does Recessions Eliminate Incentive Effects?

In the debate over whether to extend unemployment benefits, supporters of extended benefits have dismissed concerns about the disincentive effects by arguing that while that may be a valid objection during a boom, it is irrelevant during recessions when there are more unemployed people than there are job openings.

Is this argument valid? No, for three reasons.

First of all, the official number of job openings arguably underestimates the true number of job openings, as not all businesses officially advertise them.

Secondly, even if the official number of job openings was all there was, that would still mean that there is a lot of room for a decline in unemployment.

And thirdly, and most importantly, if the unemployed are more eager to get back to work as soon as possible, this will mean that wage demands will fall, making it more profitable for employers to create more job openings.

This doesn't mean that in the absence of unemployment benefits, unemployment would disappear. But it does mean that more generous unemployment benefits increases unemployment and less generous unemployment benefits reduces unemployment.
The Swedish experience during its latest recession illustrates this.

European Upswing Confirmed

Confirming the upswing in European growth I mentioned yesterday, both British GDP numbers and German business confidence came in a lot stronger than expected.

When Safe Haven Status Can Be Negative

Ambrose Evans-Pritchard report on the losing battler of the Swiss National Bank who has invested massively in trying to limit the appreciation of the Franc.

The Swiss National Bank is essentially caught between a rock and a hard place as both the intervention and non-intervention alternatives are loss making. If they continue to intervene then investment losses will continue to grow as the inevitable rise of the franc reduces the value of its foreign currency holdings. The losses so far are estimated at over 14 billion francs or more than €10 billion.

If on the other hand they cease intervening then the short term investment losses will grow even bigger as a faster franc appreciation will cause even bigger losses. And furthermore, further dramatic franc appreciation will seriously damage Swiss exporters.

This illustrates that for a country perceived as a safe haven by the markets. it is in fact better to be in a currency union. Germany like Switzerland gets to enjoy low interest rates on its government bonds, but unlike the Swiss they don't have to lose money on currency market interventions nor do their exporters risk the kind of exchange rate shock that Swiss exporters suffer from. For this reason, and many others, the scenario of a German exit from the euro can be ruled out.

European Growth Heats Up Again

While Keynesian pundits have argued that Europe due to its austerity measures will barely grow at all-and grow much slower than in America-, most signs point to accelerating growth.

Industrial production in the euro area in May was up 0.9% compared to the previous month and 9.4% compared to May 2009, while industrial new orders (a leading indicator of future industrial production) in the euro area in May rose 3.8% compared to April and 22.7% compared to May 2009. Meanwhile, both the manufacturing and non-manufacturing surveys for July showed accelerating growth.

Just because growth is robust -especially by European standards- right now doesn't necessarily mean of course that it will stay that way. However, the biggest risk factor isn't really the austerity measures. Latvia had above average growth both with regard to industrial production (+13.2%) and even more so industrial new orders (+69.0%) "despite" its tough austerity program. Instead, the risks consist of a potential downturn in America and a potential serious slowdown in Asia, as well as further rapid appreciation of the euro (which is up about 8% from its lows).

Observations Related To A Predator Attack

By "Predator", I don't mean Predator drones, nor the fictional extraterrestrial species known as "Predators", but a organism that feeds on hunted prey, also known as carnivores.

More specifically it is a clip of a Lioness performing a really elegant and successful attack on a Zebra.

Some of you may perhaps not feel inclined to be impressed by the elegance of this attack because you pity the ambushed Zebra. But while one can perhaps pity the individual Zebra, the fact is that this is positive for wild life.

Because Zebras, much like all other animals, can't produce food, this means that the potential number of Zebras (or herbivores in general in their areas) are limited. If lions and other predators were exterminated, then food shortages would arise, ultimately killing as many herbivores by starvation (or diseases) as are now being killed by predators.

Thus, the first lesson is that predation does not really reduce the number of herbivores, while enabling the existence of carnivores/predators.

Another observation is that humans are very different from animals in one important aspect. While animals (whether herbivores, omnivores,carnivores or parasites) can't create food or other resources, and instead simply has to rely on whatever is available in nature, humans can create new food and other forms of resources. Because humans can develop technology and in other ways use resources in a more efficient way, the number of humans isn't fixed, and can continue to expand as more people means more minds that can use resources in a more intelligent way.

Thomas Malthus warned some 200 years ago when the world only had about a billion people that we would run out of food, yet now when there is nearly 7 times as many people, food production per capita is at a record level, despite being inhibited by developed world farm policies that pays farmers to limit production and which limits new ways to expand production. This is why concerns about "over-population" is completely misguided, at least as long as the world isn't ruled by irrationalist ideas that prevent continued expansion of the output of food and other things.

An observation related to both of these two preceding observations is that human meat consumption is not a threat to the species used as food, but in fact something that advances it. The only reason why most domesticated pigs, cows, chickens, turkeys etc. can survive is because they are given food created by human farm technology, and because farmers have the incentive to feed them with it. But assume that suddenly everyone became vegetarians. Then the incentive to feed these animals would disappear, and then the animals themselves would likely disappear.

Thus, while the "animal rights" movement sometimes present themselves as being pro-animal, they are in fact working against the very existence of the animals they claim to care about. At least assuming that the animals are raised in decent conditions, it should therefore be clear that eating meat is pro-animal, as it allows more animals to exist.

Krugman's Icelandic Myths Has Melted

The Center for Geoeconomic studies has provided a good refutation (thank you Edward for the tip) of Paul Krugman's post where he argues that Iceland has fared well during the recent slump because it has been able to debase its currency.

See also my post on Iceland, which based on income-based indicators provide an even grimmer picture than the one suggested by demand-based indicators (These two should yield the same result since they are supposed to describe the same real world phenomenon, but since they are based on different data sources they usually differ somewhat. The truth usually lies somewhere in between).

The World Is Bigger Than You Think

Thinking about the case of Singapore gives you a lot of perspective on the issue of "over-population". A lot of people worry about over-population of this planet, worries which have existed ever since the day of Thomas Malthus 200 years ago, when the world had only about a billion people.

The Earth currently has a population of 6.85 billion. With a total land mass of 148.65 million square kilometers*, this implies a population density of about 46 per square kilometer. True, it is arguably misleading to include Antarctica'a land mass as it is basically uninhabitable due to the intolerably cold conditions, but even then we still have 133,93 million square kilometers of land, implying a population density of about 51 per square kilometer.

By contrast, In Singapore we have 5 million -very prosperous- people on a mere 710 square kilometers, implying a population density of over 7,000 per square kilometer.

And yet despite this unusually high population density, Singapore still find room for several military bases (with the Army, the Air Force and Navy each having several bases) as well as a national park.

If the world -excluding Antarctica-, had only a tenth of the population density of Singapore, thus allowing quite a lot of military bases and parks and agricultural fields, then it would still be room for 93 billion people, which is to say nearly 14 times as many as today.

Thus, there is no risk at all of the world becoming over-population in the sense of becoming over-crowded. And "over-population" in the sense of not having enough resources is only a risk if socialist and other irrationalist ideas prevent the expansion of output.

*1 square kilometer is roughly equal to 0.39 square miles.

The Myth Of The Thrifty Rich

When trying to justify why they oppose extending the Bush tax cuts, despite their general aversion to austerity and preference for "stimulus", leftists asserts that the rich supposedly save more than others and that a more effective stimulus therefore would be to let the tax cuts expire and give the extra revenue to others.

But there are at least three problems with this plab. First of all, what if due to Republican and Blue Dog Democrat opposition, the handouts to others aren't politically possible? Wouldn't it then given the alleged dangers of austerity be a second best solution to make a deal with the Republicans and extend the tax cuts to prevent the austerity chock from higher taxes next year?

Secondly, even people who save spends as their savings are invested and helps increase either domestic investments (if invested domestically) or net exports (if invested abroad).

Thirdly, as this New York Times article makes clear, it is actually a myth that people with high income are more thrifty than others:

"the Top 5 percent in income earners — those households earning $210,000 or more — account for about one-third of consumer outlays, including spending on goods and services, interest payments on consumer debt and cash gifts, according to an analysis of Federal Reserve data by Moody’s Analytics....

....By spring of last year, the savings rate — which represents the percentage of after-tax income not spent — of the top 5 percent of income earners had turned negative, according to the analysis by Moody’s Analytics. That meant the group was spending more than it made.

Less well-off consumers remained more frugal, most likely constrained by unemployment, declines in home values and the disappearance of easy credit."


It should thus be clear that even from a Keynesian perspective, extending the tax cuts makes sense.

Should Paul Krugman Vote Republican Now?

For months, Paul Krugman has relentlessly argued the case for a bigger government deficit (or "fiscal stimulus" as he prefers to call it). Now he says that Republicans want to increase the deficit by cutting taxes. Doesn't this mean that Krugman now should vote for and endorse Republicans?

Or is Krugman as hypocritical as he accuses Republicans of being?

Demand & Economic Growth

A Swedish reader asked me to comment on this argument that he heard (translated by me):

"The National Product consists of paid activities- It is income generating activity transactions. In order for that to arise someone has to demand these activities. Someone has to pay in order for someone else to get paid. It's as simple as that. Demand is the direct cause of the National Product. If there is no demand for a certain service, then it won't be performed.

Take the example of a hair cut. It won't take place if the barber simply cuts with his pair of scissors in air. A customer that demands the hair cut is required for it to be performed in the first place. And the number of hair cuts isn't pre-determined or determined by any "structural factors". When you walk into a "drop-in-salon" or lay yourself on a barber's chair, the number of performed hair cuts will increase"

So what's wrong with this reasoning? Nothing directly, actually. If no one wants a certain product, and in the context of GDP statistics, is willing to pay for it, then these products will never be produced or will at any rate have no value. If ypu produce stuff that no one wants than the value of that stuff is zero. The same thing is essentially true in the case of services: if you offer services that no one wants then the value of these services is zero.

In order for stuff to have any value they have to be supplied, and demanded. You can't have one without the other.

However, the reasoning seems assume that if things are demanded then they will simply appear. That is true as long as the people who demand it can find and interact with these people. But that is often not the case, not least during recessions. During recessions, producers stand ready to produce investment goods, but since only few people for good reasons (little or no market exists for the final products they produce) see the purchase of that profitable, these products aren't demanded.

So while it is true that a necessary (but not sufficient) requirement for products to be valuable is that they are demanded by someone, this doesn't imply that "lack of aggregate demand" is the key to understanding recessions. Instead the key is to understand that the offers made by producers mismatch with the demands of consumers and other producers, something which is often the result of central bank manipulation of interest rates, as Austrian Business Cycle Theory explains.

Impressive, Most Impressive

Singapore's growth continues to be extraordinarily high, even by Asian standard, with GDP rising by nearly 6% (26% at an annualized rate) compared to the previous quarter and 19.3% compared to the previous year. Some countries don't even manage to grow 19.3% in a decade.

Much of this boom represents a rebound from the sharp but brief slump in 2008 and early 2009, but even seen over a longer period of time, Singapore's growth has been a lot higher than most other advanced economies, something which in turn is largely a result of Singapore's low tax rates, low level of government spending and high level of economic freedom in general.

The Dangers Of Premature Jumping To Conclusions

After it became clear which teams had qualified for the quarter finals in the World Cup in soccer-football, some pundits argued that the fact that only 3 (Spain, Holland and Germany) out of 8 were from Europe, this showed that European dominance of football had ended. But even apart from the fact that non-European teams (Particularly Brazil and Argentina) had often been quite successful in the past, this proved to be a very premature conclusion, as Spain went on to beat Paraguay, Holland went on to defeat Brazil and Germany went on to defeat Argentina in the quarter finals and as Uruguay was defeated by first Holland in the semi-final and by Germany in the match for third place, the three top teams actually turned out to be European.

This shows the dangers of jumping to conclusions too fast and neglecting the fact that it was likely coincidences in lotting which pitted European teams against each other at earlier stages. Something which is often also the case in economic events, where coincidences could produce early results which are sometimes misleading, something which economic analysts needs to keep in mind.

Good And Bad Aspects Of U.S. Trade Report

The U.S. trade deficit increased again in May 2010 to $42.3 billion, the highest level since November 2008, and much higher than the May 2009 level of just $24.9 billion. It is however still a lot lower than the all time high of $66.4 billion in July 2008.

The good part about this is that total trade flows (both exports and imports) are increasing, suggesting a more bullish view of economic activity than suggested by other reports.

The negative part about this, apart from the accounting identity effect on GDP given a certain level of domestic demand, is that the adjustment of imbalances in the U.S. economy could be reversing as households are saving less even though government continues with its massive spending.

Furthermore, an increased trade deficit in the U.S., combined with an increased surplus in China, increases the risk of trade war.

J curve effect, Monetary Tightening Behind Bigger Chinese Surplus

After having fallen during 2009 and the first months of 2010 (briefly even falling into a deficit, though the fact that there was a deficit then largely reflected seasonal factors), the Chinese trade surplus increased in June, after a similar increase in May.

Ironically, this comes after a period when the yuan has been appreciating in value against most currencies (particularly the euro), while the previous drop coincided with a depreciation of the yuan against most currencies.

Does that mean that conventional wisdom got it all wrong and that a stronger currency increases net exports and that a weaker currency decreases it? No, not in the long run. In the long run, a stronger currency should all other things being equal reduce a trade surplus (though the effects are often exaggerated). But the short term effect of a stronger currency could in fact be to increase the trade surplus because of the J curve effect.

The J curve effect from the weaker euro was similarly probably a factor behind the drop in the German trade surplus in May.

Another explanation is the increase in reserve requirements and other tightening measures that Chinese authorities have implemented to limit bubbles and malinvestments. Monetary tightening will decrease import demand, and therefore increase the trade surplus.

Budget Deficits, Investment Demand & Interest Rates

One argument used against deficit spending is the Ricardian equivalence hypothesis: that any increase in government borrowing will be counteracted by increased savings in the private sector.

This has been mainly applied to household behavior, but there is really no less reason to assume that it can't be applied to the behavior of corporations as well, as deficits increase the risk that they will have to pay more in taxes and/or receive less subsidies.

Paul Krugman, who the latest months has been waging a relentless battle for more deficit spending, has been trying to argue against this by claiming that no evidence exist for any "Ricardian equivalence" behavior among corporations. While he acknowledges that business investments are indeed at a record low level, this according to him simply reflects a normal response to a high "output gap".

Since no clear definition of the "output gap" exists (Ask 50 Keynesians and you'll probably get at least 60 definitions), I'll leave that aside and use the proxy of capacity utilization.

It is of course true that low capacity utilization is a factor which will significantly depress business investments, as it makes no sense for a entrepreneur to buy new machinery or build a new factory if you already have it. It is also correct to argue that the current low capacity utilization is a significant factor explaining low investment spending.

However, Krugman overlooks that low investment demand will lower interest rates. That in turn has two implications: First of all, low interest rates will other things being equal increase investment demand, thus to a significant extent canceling out the investment lowering effect of low capacity utilization. Or in other words, like any shift in demand or supply, the effect on the price will reduce the effect on quantity.

And secondly, the fact that investment demand is low is a key (but not the only one) explanation why Treasury bond yields have remained low despite the hugh budget deficit. This implies that the budget deficit nevertheless has had a significant yield increasing effect ceteris paribus. If the deficit had been lower than interest rates would have been even lower, increasing investment demand.

And finally, while the "Ricardian equivalence" effect on investment demand can't be exactly quantified given the many other factors involved (like interest rates and capacity utilization), there are good theoretical reasons to believe in it, and especially given the low interest rates and the fact that capacity utilization is in fact higher than during the 2002 lows, no good reason exist to dismiss its existence.

Aussie Boom Continues-For Now

While concerns about a international slowdown prevented the RBA from implementing another rate hike, the Australian economy seems to be doing fine-at least for now. Export revenues (amd the trade surplus) is booming, and so is employment.

So for now, the Australian economy looks strong. However, even the modified mining tax that will soon be implemented by newly appointed Prime Minister Julia Gillard will hurt the mining industry, And perhaps even more importantly, a likely global cyclical slowdown or downturn will likely reduce the prices of Australian export commodities.

This means that great downside risks exists for the Australian economy-and for the Australian dollar.

Canadian Myths About Spanish Employment

Stephen Gordon at "the Worthwhile Canadian Initiative" blames the disproportionate job losses in Spain compared to the allegedly smaller differences in job losses between different American states, on the lack of fiscal federalism or alternatively monetary nationalism (the existence of national currencies).

First of all, Gordon's use of Fed districts are arguably misleading. If we look at data on the American state level you can see even bigger differences than between Euro area states. For example between May 2007 and May 2010, Nevada saw a 14% drop in employment while North Dakota saw an increase in employment by nearly 4% during the same period. Does that mean that Nevada should be sorry for having the U.S. dollar as currency instead of a "Nevada dollar"?

Secondly, I have discussed the Spanish situation before, and as I pointed out then, contrary to popular myth the drop in output has in fact not been bigger than in the rest of the euro area.

Why then has employment fallen more in Spain than in the rest of the euro area? Well, because output per worker has increased more. There are in turn two main explanations for that obvious accounting identity truth. One that I discussed in the previous post: namely that during the boom a lot of immigrants with low productivity got jobs in Spain, something which contributed to a much stronger increase in employment than in output during the boom years. When the crisis came, these low productive immigrant workers lost their jobs first, something which meant a bigger drop in employment than in output.

The other reason for why output per worker has been stronger in Spain than elsewhere is that some other countries , most notably Germany, has paid companies to reduce working hours per employee rather than reduce the number of employees when demand falls. Regardless of what you think of the merits of this policy, it is not related to the issue of monetary unions. By contrast, Spain has not pursued such a policy.

Why Is There A Catch-Up Effect?

In the previous post, I mentioned the existence of a catch-up effect. Since that is rarely, if ever, discussed in most economics books (whether Austrian or non-Austrian) many of you may be unfamiliar with it, and why it occurs.

When Western societies started to industrialize and move from poverty, growth was relatively slow. While GDP statistics were usually not collected, most modern estimates of growth during that era suggest that growth wasn't that much higher than growth today.

By contrast, growth in countries that now industrializes, such as China and before it many other East Asian countries have been much higher than in Western countries. Does that mean that East Asian policy makers are much wiser than 19th century Western policy makers? No, at least not necessarily.

The key reason why they industrialize so much faster than the first countries that industrialized is instead the catch-up effect. As the name suggests, this effect is involved with poorer countries catching up to richer countries. When the first countries industrialized they were the richest countries, and so they couldn't catch up to anyone, hence they didn't benefit from the catch-up effect.

But why does the catch-up effect occur? Mainly for two reasons. One is the fact that poorer countries today have all the modern Western technology available, and can thus go from pre-industrial technology to late 20th early 21st century technology almost immediately, enabling a far faster technological advance than was available in 19th century Western countries, something which in turn implies a much faster increase in productivity.

The other key reason is trade. When Western countries were at a similar stage of development, they didn't have large export markets in wealthier countries, and thus couldn't specialize in producing goods for those markets where they had a comparative advantage, as those markets didn't exist. By contrast, China for example, can specialize in producing for large export markets labor intensive goods where they due to their low wage levels have a comparative advantage.

If somehow it was possible to stop all technology transfer and if Western markets had been closed, China and other East Asian countries would have likely not grown any faster than 19th century Western countries did.

Another way of looking at the catch-up effect is to imagine two individuals that are equally talented, motivated and so on, but that one of them lives in New York in 1810 and the other lives in New York in 2010. Since the person living in 1810 didn't have access to computers, phones, TVs, subways, cars etc., and since the number of people he could have worked with and for was much smaller (both due to a smaller overall population in New York, America and the World, and even more importantly due to much worse transportation and communication systems), it is quite obvious that the person living in New York in 1810 would have a much lower standard of living than the person living in New York in 2010, despite not being intrinsically better.

In this analogy, 19th century Western countries are like the person living in New York in 1810 while China and other East Asian countries are like the person living in New York in 2010. The reason why the latter have it so much easier than the former are not really that they are really intrinsically better than the former, but that the latter work in a much more favorable environment with better available technology and larger markets that they can trade with.

Note however, that the catch-up effect is obviously not sufficient to achieve high growth. If a country is sufficiently mismanaged then they will remain mired in poverty despite the existence of modern technology and large open foreign markets. That is the case for nearly all countries in Africa as well as in varying degrees in certain Latin American, Middle Eastern, Asian and Eastern European countries. But if a country is relatively well managed than they will thanks to the catch up effect leave poverty much faster than was possible for a similarly well managed country in the 19th century and early 20th century.

When Will China's Economy Become Bigger Than America's?

I have long argued that it is more or less inevitable that China's economy will in a not too distant future become the biggest in the world.

I am more convinced than ever of the truth of this prediction. Each year it seems, China passes at least one new milestone. In 2008, it surpassed Germany to become the third biggest economy. In 2009, it surpassed Germany as the biggest exporter and America as the biggest car market. In 2010, it will (barring a really dramatic yen appreciation) surpass Japan as the second biggest economy.

But exactly when will China surpass America as the world's biggest economy? Obviously, we can't for sure pinpoint the exact year it will definitely happen. But we can pinpoint using basic arithmetic just when it is likely to happen.

And the numbers clearly suggests that old estimates that the shift won't happen until 2040 or 2050 are far off the mark.

In 2009, nominal GDP in America was according to preliminary estimates, $14.26 trillion. In China, nominal GDP was 34.05 trillion yuan, or $4.98 trillion using the average 2009 exchange rate. That means that America's GDP was 2.86 times bigger.

With average annual growth in America being some 7.5 percentage points lower during the 2000s, then assuming that this will continue and that the real exchange rate of the yuan will appreciate by on average 3% per year (quite reasonable, given the reality of the Penn/Balassa-Samuelsson effect and the strong pressure on China to make its currency stronger), then it will only take 11 years before the Chinese economy becomes bigger, meaning that by 2020, China's economy will be the biggest in the world.

If we assume that the growth differential falls to just 5%, while the estimated real appreciation is assumed to be just 2.5% per year, then China's economy will become bigger by 2024.

In order for the old estimate of 2040 to hold true, then we would have to assume a ridicuosly low total growth differential and real appreciation of just 3.5% per year.

Given the falling returns from the "catch-up effect" that naturally follows when a nation becomes richer, it is unreasonable to assume that the growth differential of the last decade will last forever, or even for several more decades. But since per capita income would still be much lower in China when its economy are as big as America given it's much bigger population, it is quite reasonable to expect a similar growth differential for a while, and to expect a significant real appreciation of the yuan, making it likely that the year when China will become biggest somewhere between 2020 and 2025.

Weak U.S. Employment Report

After several strong employment reports earlier in the year, and a mixed message last month, this month's employment report was decidedly weak.

While private sector employment rose somewhat according to the payroll survey, the increase was a relatively weak 83,000-less than is needed to keep pace with the increase in population. Furthermore, the average work week fell and so did average hourly earnings.

Meanwhile, the household survey showed a decline in employment by 301,000. Even excluding census workers, this implies an even weaker picture than the payroll survey.

This number confirms the picture from for example the ISM manufacturing survey, car sales and construction spending that the U.S. recovery is slowing down significantly right now.