Economic IssuesFrom Mercantilism to Stagflation

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Mercantilism

• Object is the power and wealth of the NATION STATE

• Wealth is POWER– The size of a country’s treasury

determines it’s military and political power

• Wealth equals an accumulation of GOLD through a favorable balance of trade/payments– A country needs to export more

than it imports

• Protective tariffs and trade restrictions help national industries and agriculture

• Acquisition of colonies which supply raw materials and buy finished products from closed markets

• Assumption of an uneducated, perpetually poor laboring class

Effect on the American Colonies

• Americans were expected to provide raw materials (furs, tar, pitch, tobacco, lumber, agricultural products)

• No manufacturing which might compete with English monopolies

• Trade only with England unless England has no interest in products

• Only buy manufactured goods from Great Britain

• No dreams of economic self-sufficiency or self-government

Navigation Acts

• All commerce could only be moved in British or Colonial ships

• European goods destined for America had to stop in Britain where tariffs could be collected

• Regardless of who offers the best price, certain products must only be sold to Great Britain

The flow of money

• Money goes OUT. – Colonists buy more from Great

Britain than they sell– Money used in illegal trade with

other countries drains out– American colonies not allowed to

coin money

• Perpetual shortage of currency results in BARTER

Problems with barter

• Restricts transactions and is inefficient– Double coincidence of wants is

necessary– How do you make change?

• Colonists are always in debt to banks and merchants in England

• The natural result is SMUGGGLING and ILLEGAL TRADE

Salutary Neglect and Revolution

• Foreign wars kept England distracted

• Led to lax enforcement of Navigation laws– Smuggling-many fortunes made– Higher standard of living in the

Colonies by the Revolution– Confidence in Self-Sufficiency– Resentment of

restrictions-”perpetual economic adolescence”

Rights of Englishmen

• Magna Carta, Common Law, Parliament, English Bill of Rights (1688)

• Parliament must approve all new taxes

• British theory of “virtual representation”

• Colonial belief that only their own assemblies could levy internal (direct) taxes

Market Economy

• Theory: Adam Smith’s Inquiry into the Nature and Causes of the Wealth of Nations (1776)

• Assertions– Labor, not nature, is the source of value

• Man appropriates the fruits of nature by investing his labor in them

• Private property is justified by invested labor

– Self-interest is the primary economic motivation

• Man will work harder or make innovations to benefit himself

• The market allows him to seek benefits

Market Economy (cont)

– The profit motive is the “invisible hand” which regulates the marketplace

• Competition keeps prices from going too far from production costs. Specialization and division of labor increase productivity and allow more profit.

• Self-interest motivates the producer to provide what society wants

• The laws of supply and demand create a “self-regulating market”

– The role of government is to provide for finance defense, justice and public goods

Conflict with Mercantilism

• Mercantilism required strict regulation of markets for the benefit of the nation state.

• Tariffs and monopolies are therefore reasonable.

• Adam Smith’s market economy called for a “laissez faire” government policy which would allow competition in a free market.

• Greater productivity would produce a higher living standard and thus increase the wealth of the nation.

Constitutional Issues

• Which governmental authority will have the power to determine the rules of commerce?

• Who will levy taxes and tariffs?• What rights will the owners of

businesses have?• What rights, if any, do workers have?• Who will print or coin money, and

how will its value be determined?• How will the government fund its

functions?

Hamilton Plan-Based on belief in a market economy and a

cynical view of human nature

• Assumption of state and national revolutionary war debts– Establishes credit– Allows huge profits for speculators– Creates support for the federal

government by owners of newly issued bonds financing payments

– Objections of states which had paid off most of their own debts

Hamilton Plan (cont)

• A protective tariff– Conflicts with Adam Smith’s theory– Encourages “infant industries”– Strengthens the nation by

providing jobs and self-sufficiency

• Sale of government lands at low prices– Agriculture supports cities– Prosperous farmers buy industrial

products

Hamilton Plan (cont)

• Creation of the Bank of the United States– Established with both public and private

funding– Discounts bills of exchange and

promissory notes of merchants, accepts deposits, issues sound currency, controls money supply (based on bimetallism), holds government deposits and sells government securities, lends money to the government

– Raises serious Constitutional questions-implied powers

Hamilton Plan (cont)

• Objections to the plan on the basis of:– Belief in limited power of federal

government– Prediction that this would be an

agricultural, not an industrial nation– Detrimental effects of protective

tariffs on non-industrial areas

Marshall Court

• Marbury v. Madison (1803)- Judicial Review• Dartmouth College v. Woodward (1819)-

Sanctity of Contracts (applied to business charters too!)

• McCulloch v. Maryland (1819)-States cannot tax the national government’s agencies. The bank is constitutional (applied powers)

• Gibbons v. Ogden (1824)-Only the federal government can regulate interstate commerce (broadly defined). Eventually led to regulation of transportation, broadcasting, labor unions, product quality, wages and hours, etc.

Types of ownership in a market economy

• Sole Proprietorship• Partnership• Corporation-Chartered by a state, owned by

stockholders– Disadvantages-

• Cost • Double taxation

– Advantages-Easy access to capital

– Unlimited life– Limited liability– Easy transfer of ownership– Advantages of scale

• Mass production, research, use of byproducts, pricing, efficiency, lobbying

Laissez Faire-domination of business owners

• This term was applied by others to Adam Smith’s ideas: Government should not interfere with business

• Smith never meant that the government should not pass laws regarding business and enforce them.

• By the late 1800s, industrialists expected protective tariffs and even subsidies, but they were outraged when business was regulated.

• Labor unions and farmers began calling for government intervention as the only possible “countervailing power” to industry.

Tariffs

• Revenue tariffs– Low tariffs intended to collect

income for government and allow foreign goods in

• Protective tariffs – Intended to give an advantage to

domestic industry and keep out foreign goods or raise their prices so high that they are unattractive

Banks, Banking and the Money Supply

• Functions of Banks– Deposits, withdraws, checks,

savings, safe-deposit boxes, foreign currency, money orders, traveler’s checks, trust services (money management and investments), loans to businesses and individuals

What is money?

• Anything people will generally accept as payment for goods, services or debts

• Function– Medium of exchange (can be earned

and spent in many ways-no coincidence of wants is necessary)

– Standard of value (allows us to compare costs)

– Store of value (can be saved for future use)

Money Standards(gold, bimetallism, fiat money)

• From the time of Washington’s administration until 1900, the U.S. used a bimetallic system to back its currency

• The problem with this is that the relative value of gold and silver fluctuates.

• If two kinds of money are available, people will hoard the more valuable/stable and spend the less valuable/stable

• When the government didn’t adjust rates promptly, gold money would start to disappear

• From 1900 until 1933, the U.S. was on the gold standard.

• During the depression, the U.S. went on a modified gold standard.

• Only in certain circumstances could dollars be redeemed for specie.

• Silver certificates were printed

• In 1971, due to our unfavorable balance of trade with oil exporting countries, the U.S. went off the gold standard altogether.

• There is now a floating exchange rate internationally

• This is based on a money market much like the stock market

• Banks bid on currencies of other countries and the rate depends on supply and demand.

• If other nations want to buy American goods, the value of the dollar rises.

• Today the U.S. dollar is FIAT money. It is worth something because the government says you have to accept it for payment of debts (it is legal tender)

• You cannot redeem it for precious metals, but you can buy valuable goods with it

Federal Reserve

• The Federal Reserve was created in 1913 to:– Address banking panics– Serve as the central bank of the U.S.– Supervise and regulate banking

institutions– Protect credit rights of consumers– Manage the nation’s money supply

through monetary policy– Provide financial services to depository

institutions, the U.S. government, and foreign official institutions

– Strengthen U.S. standing in the world economy

Inflation

• Inflation is characterized by rising prices.

• It occurs because costs have gone up, or because demand has increased

• In the U.S. we like a LITTLE inflation. It makes the GDP go up and brings job creation

• Rapid inflation, however, can have drastic results. People need to know what to expect.

Inflation (cont)

• Who benefits?– Debtors (debts are easier to pay since

wages are generally higher)– Professionals who can increase their

charges or union workers who can force increases by striking

– Producers of necessary goods

• Who is hurt?– Lenders (who get back cheaper dollars)– People on fixed income– Producers of luxury goods

Stagflation

• A period of inflation combined with stagnation– (slow economic growth and rising

unemployment)• Began to afflict many countries in the 1970s• Can occur when a country is shocked by an

unfavorable price shock (think oil)– Raises prices while at the same time slowing the

economy b/c it is no longer as profitable to produce

• Made worse when central banks use excessively stimulative monetary policy to try to avoid the resulting recession (stagnation), causing a runaway wage-price spiral