The Short Run Weekly Issue 74

Fellow Shortrunners,

The Short Run maintains an economic chat board for its visitors to place questions, comments, and ideas for discussion. I encourage Shortrunners to visit the board and have a hand at asking, and in some cases answering questions, as interaction can be a powerful learning tool. That said, a good question was placed in the forum earlier this week, and I'd like to spend this newsletter providing some response to it. The question was "Why does the theory of consumption occupy such a central place
in macroeconomic theory?"

Rather then spend time discussing actual theories of the consumption function, (which I did in issue #38 and can be found in the newsletter archive) I'd like to focus on a narrower component of the question, why they have such an important role. When economists talk about the theory of consumption they are suggesting a possible model for the motivations for consumers to spend their money.

Economics is a relatively young science. That said, one of its pivotal moments came in the 1930's when economists realized that their current economic tools could not explain the recessions felt by the United States and Great Britain and, to a lesser extent, the rest of the world as a whole. Theories regarding declining trade and aftershocks from the first world war offered some explanation, but the most convincing and purely economic argument came from an English economist named John Maynard Keynes.

Having studied under the imminent economists of the time, he realized that what was stifling the world's economies was not a supply side problem. The blame for the Great Depression and economic fluctuations couldn't be placed on the workers or the managers or the factories. Indeed, it lay with
the consumers. When people began to perceive economic slowdown, they cut back on consumption, a decline in the demand side of the economy. At the same time, consumers and investors cut investing activities in a reduction of what Keynes had called "Animal Spirits."

If changing consumer sentiment and spending patterns then were a major impact on fluctuations in economic activity, Keynes perceived, then there was a role for government in stabilizing that demand. In fact, the understanding that an economy could slump simply because people chose not to consume as heavily has shaped the nature of economic policy debates as well as impacted a great number of actual political and economic decisions over the years. Studies have focused on understanding exactly how policy tools can be molded to impact consumption differently, and while policy makers don't always buy into economic research (which is often conflicting) there are mainstream ideas which do offer notable solutions to demand problems.

This new understanding still has relevance today. Economists in the US are concerned about the conflict in Afghanistan, the events of September 11th, and the Anthrax scares, not because military activity will significantly impact the economy, or New York's Economy may fall into recession, or even because of a few isolated cases of Anthrax. The larger economic worry comes from the change in people's willingness to consume. If people don't buy products because they are worried about their uncertain financial future, then the people who would have normally sold those products are now out of the job, and in a sort of vicious cycle, the economy slowly shrinks. Research and practice have offered solutions and a better understanding of what motivates people's consumption decisions, and it won't be difficult to see these motivations play into major decisions in the coming months. Tax cuts and rebates, state and local spending projects, and monetary policy actions will be implemented in such a manner that they are focused on making sure that demand doesn't dry up, that people keep their jobs, and that the economy continues to move forward.

Sincerely,
Daniel Hicks

Economic Releases

The data section provides charts and data for the most important economic indicators.

Index of Leading Indexes: 0.5%

During September, the index of leading indicators dropped a hefty 0.5%. The decline was in a large part due to the drop in the stock market, but several other components declined as well. The coincident index, which measures current economic activity, and the lagging index, which measures past economic activity, both declined as well, indicating that indeed the economy may already be in a recession.

Jobless Claims: 504,000

Jobless claims broke the 500,000 mark last week rising to 504,000. Continuing claims released alongside initial jobless claims rose to a 10 year high as further weakness is becoming evident in the US labor market.

Durable Goods Orders: -8.5%

In a largely unexpected collapse, durable goods orders placed in September declined 8.5%. The index saw major drops in industries such as aircraft and communication equipment. Aircraft orders, because of their size, impact this index heavily and it's obvious that there was a drastic change in the demand for aircraft and new air orders was likely to decline following the events of September 11th.

Employment Cost Index: 1.0%

The ECI rose a percentage point during the third quarter, slightly above expectations. Overall signs of inflation, particularly with respect to the labor market, are unlikely to develop in the near future, despite the climate of low interest rates. The release also suggests that wages in the manufacturing industry are suffering more heavily as the industry itself remains routed in a deep recession.

Existing Home Sales: -11.7%

In what is the largest single month decline I have ever seen, existing home sales plummeted 11.7% during September, a clear indication that the housing market and consumer spending overall are likely to come under serious downward pressure following the events of September 11th. It's difficult to asses whether the conflict in Afghanistan and the Anthrax scares will increase the damage, but at any rate it is apparent that the once strong housing market is starting to crumble.

New Home Sales: 864,000

New Home Sales declined as well during September, although much more modestly. It is likely that the impact of the disaster is likely to show up in future data for this series. The mortgage rate declined to a new low of 6.8% amid the new interest rate cuts, and it will be interesting to see how much impact this will have on the market.

ECRI Weekly Leading Index: 114.3

The ECRI Weekly Leading Index declined to 114.3 last week. The move was a continuation of a trend that has been readily apparent in the index for some time, and the index as a whole is suggesting that the US is heading for a recession if not already in one.

Classroom

Check out the new classroom section and watch for it to grow and change in the coming weeks as we implement drastic reconstruction to the section. Comment and suggestions as to the best method for this kind of a section would be extremely helpful.

Articles / Book Reviews

Newest Articles:

Balance East and West
- Contributed by Kautilya AKD

Bush's Tax Plan Just Doesn't Cut It
- by Alex Rothenberg

Newest Book Reviews:

Money and Power by Howard Means
The Firm, The Market and The Law by Ronald Coase
Megatrends Asia by John Naisbitt
Geography and Trade by Paul Krugman
Fuzzy Math by Paul Krugman
Growth Theory: An Exposition by Robert Solow