ECONOMIC LITERACY
by Bob Parvin
America's Economic Report Card
ECONOMIC LITERACY
by Bob Parvin
America's Economic Report Card
The problem with most traditional economic principles textbooks is that they focus on neoclassical economic theory rather than the reality of the behavior of business firms. See, for example, Why economics textbooks must stop teaching the standard theory of the firm, which is a bit technical.
Perhaps the most important thing that one can get from studying economics is an informed economic skepticism. We must be skeptical of claims for more or less government intervention in business and for economic panaceas in general. We need to study the arguments and evidence on both sides of the issues before we make a judgment. In economic policy debates we need to consider the advocates' economic credentials, self-interests, and ideological biases. It is not often that we have economic debates in the media between competent and unbiased people. This is especially true in the case of politicians who are inclined to spout the party line. In the business world we need to be skeptical of advertising claims, investment advice, and corporate income statements.
When I think of my introduction to economics in 1942, I don't have a warm and fuzzy feeling. The course was taught by the fearsome Professor Dumeier who ate sophomore econ students for lunch. He co-authored our textbook and didn't deem it necessary to lecture since everything was so expertly covered in his no-nonsense text. Instead of lecturing he conducted an inquisition by asking students one by one to answer the questions at the end of each chapter, and woe to the hapless student who couldn't spit out the prescribed answer. When the professor came to the topic of international trade, his eyes bulged in anger and the spit flew as he railed against the Smoot-Hawley Tariff Act of 1930, which contributed to the Great Depression. (In 1942 we were just shaking off the depression with the economic "shot in the arm" provided by armament production.) At this point in the course a student was well advised to master the principle of comparative advantage, which will be discussed below.
Capitalism is a part of our state religion, but what is the nature of modern capitalism? A capitalistic economy is one in which (1) the means of production are mostly privately owned and the production decisions are mostly privately made and (2) producers are guided mostly by market sales.
There are no pure "free market economies" guided solely by Adam Smith's "invisible hand." All capitalistic economies are actually mixed economies in which the relative importance of the "invisible hand," the "monopolist's hand," and the "government's hand" varies. For an excellent short discussion of the "free market" ideal go to Wikipedia, Free Market.
Not only do we have a mixed economy, but we also have mixed capitalism depending upon the market. Almost half of non farm business firms employ 1 to 4 people and are mostly owner-operated, but almost half of business revenue is produced by firms having 500 or more employees and are mostly managed by hired managers. (A third of business revenues is produced by firms having 5,000 or more employees.) So we have two significant size sectors (small business and big business) in our capitalistic economy, and the style of capitalism in the two sectors is very different. The capitalism in the big business sector can be called corporate capitalism in which management is separated from ownership and in which many industries are dominated by a few very large corporations. (See below for the discussion of oligopolies.) Multinational corporations are players in economic globalization.
Markets
Markets result from the desire for specialization and trade, the benefits of which man found very early on. If one person was an excellent hunter and another was an excellent gatherer, they could both enjoy a more bountiful table by trading nuts and berries for rabbits and mastodon roasts.
Eventually money was invented and marketplaces arose. Acting in their self-interest, sellers offer products with the hope of making a profit, and buyers buy goods with the hope that they will provide satisfaction of their desires at a minimum cost.
In every economy the following decisions are made: 1) WHAT to produce, 2) HOW to produce it, and 3) FOR WHOM to produce. Who makes these decisions? In a command economy they are made by a central government authority. In a perfectly competitive market economy they are made by the market mechanism through market prices and sales that provide signals to which producers respond.
Laissez faire (leave it alone) economists have believed that the market mechanism or "invisible hand" will automatically answer the WHAT, HOW, and FOR WHOM questions so as to maximize economic welfare. In the next section we will consider why the market may fail to do so.
Currently there is considerable conservative enthusiasm for "privatizing" government functions. If the government were producing autos, we would probably be driving clunkers like the Russian Yugo. However, the provision of many services such as fire protection, education, and health care do not lend themselves so readily to privatization. For example, the evidence seems to indicate that where public schools have been privatized or made into charter schools, the new schools on the whole are not performing any better than the old public schools.
Although there has been a lot of deregulation, there are markets where the government has successfully bucked the law of supply and demand. The most notable are the rental markets in some cities such as New York that have at least some apartments under a rent cap, which is an anomaly in a free market economy. We want affordable housing in our cities, but it won't be built or even properly maintained unless landlords can make a reasonable return on their investments. One solution commonly used is "soft" rent control that regulates such things as the rate of increase in rents. This prevents rent gouging in times of a short supply of rental units.
Other cases of market interference are minimum wage laws. They raise wages above the market equilibrium level, which troubles economists. Minimum wage laws cause some unemployment among entry-level workers. On the other hand there is the argument that full time workers should receive a living wage. Unions also raise wages above the market equilibrium level. However, it is often argued that workers must have the power to stand up to the market power of employers. In the labor buyer's market that has existed since the decline of manufacturing in the US minimum wage laws and unions have become more important to protect the welfare of workers. What is more difficult to defend are archaic and inefficient work rules used to protect jobs.
Futures Markets
At first there were only spot markets where commodities were sold for cash and delivered immediately. Suppose that a grain dealer bought 10,000 bu. of wheat in September after harvest to be sold in January, and the market price dropped before he could sell the wheat. He could take a nasty loss. So dealers and processors started making forward contracts with buyers in which they agreed to take delivery of the wheat or rice or wool or whatever at some time in the future, and the futures market was eventually borne.
Buyers hedge their purchases in the spot market (their "long" position) by selling "short" an equal amount of the commodity in the futures market. If the price subsequently goes down, they make money on their "short" contracts and lose on their "long" positions.
The futures market enables dealers and processors to hand off the price risk to commodity speculators, who are really nice people performing an important economic function. (They are not like those currency speculators that cause panic in small countries.)
Futures contracts are derived from underlying commodities, so they are one form of a derivative. Another example is an ordinary stock option whose value is derived from the value of the underlying stock.
To learn more about futures trading go to A History of Futures Trading in the United States.
Types of Business Firms
There are four factors of production: labor, land (includes minerals), physical capital (goods used for the production of other goods), and entrepreneurship. Entrepreneurs are the poster people of capitalism. They organize, manage, and assume the risks of a business. They form three main types of business entities. If the entrepreneur goes it alone, the business will be a sole proprietorship. The entrepreneur can start a business under his/her own name (John Jones Restaurant) or register or file an assumed name (The Good Eats Restaurant).
If the entrepreneur needs to assemble capital, he/she can form a general partnership with someone and operate under a partnership agreement. General partnerships have the disadvantages of each partner having unlimited liability for claims against the partnership. For this reason it behooves one to find a partner that is really, really trustworthy. There are also statutory limited liability partnerships or companies, but in borrowing money each partner may still may be required to be personally responsible for the full amount of the debt.
If the entrepreneur wants to raise a lot of capital or to have several owners not involved in management, he/she may want to form a corporation, which begins as a closed corporation. When more capital is needed, the corporation may go public and have an IPO (initial public offering). (Common stock generally confers voting rights and is entitled to dividends subject to the prior claim of preferred stock, which is paid dividends in a specified amount and is usually nonvoting.) The stockholders are not usually personally liable for claims against the corporation. It is necessary to file articles of incorporation with the state who then issues a certificate of incorporation which along with the articles constitutes the corporate charter. Bylaws are prepared which are the rules for managing the corporation. Did you ever wonder why so many national corporations are incorporated in Delaware? Go to Learn about Delaware.
Corporations often have the urge to merge. Possible reasons may be sound business considerations or they may be unrealistic aspirations, herd mentality, or the personal interests of CEOs. How many of the large mergers can you think of that proved to have real "synergy" and were successful? One of the big mergers was Chrysler and Daimler in 1998. A news release said, "The 30 top executives at Chrysler will receive over $500 million in cash and stock when the merger with Daimler-Benz is finalized." So how did that happy marriage turn out? Daimler dumped the bride in 2007.
In a merger the two corporations are terminated and a new corporation is formed. In the case of an acquisition one corporation buys another corporation that may be terminated or made a subsidiary. If the two corporations operate at the same stage of production (e.g., both are car makers), it is a horizontal merger. If, for example, one mines iron ore and the other makes steel, it is a vertical merger. If they are in entirely different businesses, it is a conglomerate.
What ever happened to antitrust enforcement? To find out go to The Threat from Mergers. What exactly did the early "trust busters" bust? These "trusts" were business combinations for the purpose of creating a monopoly or restraining trade. The trusts were voting trusts in which the trustee voted the majority of the stock of the corporations involved. For an interesting story on how trusts were used to restrain trade go to Standard Oil.
The laws with respect to business entities may be a little different in every state. For an example, see the types of Texas firms described in Selecting a Business Structure.
Although in the real world the market mechanism does a remarkable job even though there is no central guidance and everyone is acting in his/her self interest, it can fail to maximize economic welfare. In such instances there is a sound case for government intervention. We will look at three traditional textbook sources of "market failure." Later, we will look at "business management failure."
1) Market Power
When an individual firm can alter the market price for something it produces, it has some degree of market power. In a monopoly situation one firm can set the price and maintain it. To maximize profits, the monopolist reduces production and increases prices to the detriment of consumers. The most common monopoly problem is the sole producer of a good or service in a small community. An example is a single newspaper, radio station, or pharmacy in a small town. Monopolists like to erect barriers to entry of other firms. One legal way is by protecting its product with key patents. They may also create protective layers of subsidiary patents and pursue an aggressive patent infringement litigation policy to scare off possible competitors.
Imperfect competition often takes the form of oligopoly (a few firms dominate a market). An oligopolistic industry tries to behave like a monopoly in restricting output to maximize profits. Since outright collusion is illegal, a price leader in the industry may call the signals, and the others may follow. Sometimes they secretly enter into illegal price fixing or market allocation agreements. Another form of illegal behavior is predatory price-cutting to drive out competition.
An example of an oligopoly is the breakfast cereal producers. Four firms produce about 85% of the domestically produced breakfast cereals. Breakfast cereal is not a high tech product or one where economies of scale are important, so why aren't there more small producers? Each large producer has a line of products that it insists that a store put on its shelves and has a large advertising budget. Since there are a great many items on the shelves, what is the problem? Since the large producers market mainly to kids, most of their products are highly processed and high in sugar and gimmicks. There is less profit in minimally processed whole grain cereals, and they are harder to market to kids. So there is market failure because the product mix is not optimal from the standpoint of real variety and nutritional standards.
A more important oligopoly is the pharmaceutical industry. A good example of product differentiation (making small differences that appear to make a product different than its competitors) is their "copycat drugs," but you won't find much real price competition.
Having large oligopolistic firms makes it easier to exploit the economies of scale in producing items like automobiles. However, for producers another equally important advantage of larger size is the ability to bully suppliers and put pressure on politicians.
A classic example of market failure relating to market power was the 2001 California electricity crisis after California had deregulated power generation "to let the market work its magic," but instead it unleashed corporate greed and malfeasance. The producer friendly Federal Energy Regulatory Commission found no evidence of foul play mainly because they were not inclined to look. However, Enron and the electrical producers did in fact rig the market. Producers deliberately shut down generating plants to create a shortage that pushed electrical prices sky high. The result was that California paid roughly $30 billion in excessive electrical bills. This is a story of both market failure and government failure.
If several firms elbow their way into the oligopolistic industry, the situation may change to monopolistic competition (many firms producing similar products). Each firm establishes a "monopoly" on its individual brand mainly by product differentiation through advertising. This is the most prevalent form of imperfect competition.
2) Externalities
For consumers to get the optimal product mix through the price mechanism the cost of production must include not only the private costs of the producer but also any costs or burdens on bystanders. For example, pork is now often produced in large "pig factories." The wastes are pumped in waste "lagoons." (Don't you love that euphemism for cesspool?) They create a stench and pollute groundwater. If the pig producers had to pay to fix the problem or compensate their neighbors so that the private costs equal the total social costs, the price of pork would rise, and less of it would be produced improving the allocation of resources. Economists call this difference between private cost and total social cost a negative externality. There are also positive externalities such as the beauty of a flower farm.
3) Inadequate Public Goods
Public goods are products or services that we collectively use or consume such as highways, schools, libraries, parks, sanitation systems, national defense, and police and fire protection. The market tends to under produce public goods.
We could add quality and safety deficiencies to the usual list of market failures.
For more information on market failure go to Market Failure.
Macro Failure
"Macro failure" is at the macroeconomic level of the economy as opposed to the microeconomic level of the firm. It is the failure to achieve full employment and price stability. Government intervention may be sought to increase employment or control inflation.
The Great Depression was an example of catastrophic "macro failure." The problem then was to stimulate demand, production, and employment and curb deflation rather than the more common problem of curbing inflation. The New Deal pump-priming measures helped, but it took the massive government spending in World War II to achieve full employment.
Government Failure
Government intervention is a blunt instrument, so we must consider the problem of "government failure," which is making a bad situation worse. Libertarians argue that the government may do a worse job than markets because of bureaucracy and the pernicious political influence of special interests. Government failure is seen by liberals as a much smaller and easily avoidable problem than market failure.
Adam Smith believed that entrepreneurs (those who start and grow their businesses) acting in their own self-interest unintentionally leads to the best economic interests of society. Entrepreneurs often maximize their income by producing superior products or services at competitive prices. There are also those who try to increase their profits by cutting quality or safety, misrepresenting their products, and using unfair business practices. However, generally in the long run what is best for their companies' interests is best for their self-interests.
When hired management takes over, there is a new ball game. The hired manager also tends to act in his own self-interest, which is not entirely the same as his company's interests. To the extent that these interests diverge, the economic efficiency of the company suffers. In large corporations there is often a very weak connection between management and ownership. Enron has become a textbook case of what can happen. For a very instructive article see Learning the Lessons of Enron.
As this was written, I read about a large corporate acquisition in which the CEO of the acquired corporation will retire with a golden umbrella amounting to more than $150 million in benefits. One wonders if selling his company was as much in the corporation's interest as in his own interest.
A fundamental principle of economics is that incentives matter. To get the optimum performance from managers, they must be compensated in a way that aligns the manager's interests with the long-term owner's interests. When stock options are the major part of executive compensation, the CEO has the incentive to goose current earnings to push up the stock price. He may do it by cost cutting that removes more muscle than fat. This includes mass firing of workers and big cuts in R & D. He also may do it by aggressive if not fraudulent bookkeeping.
There have been in recent years a number of corporate scandals in which there was fraudulent bookkeeping, insider trading, outrageous executive compensation, and ineffective corporate governance, but for every case of wrongdoing that landed in the headlines, how many cases didn't? Not only do executives act in their own self-interest but so do some auditors, lawyers, investment bankers, and investment analysts and writers who serve greedy executives. There have been some useful reform measures, but until the corporate culture changes and enforcement is adequately funded investors have reason to be skeptical.
Investor and consumer welfare depend upon business behavior, which depends upon the character of business people and upon rules of fair play and their enforcement. Competition does not automatically weed out the wrong-doers. The "invisible hand" will not guarantee acceptable performance unless it holds a club.
Money Cost vs. Opportunity Cost
The concept of opportunity cost is one of the simple but big ideas in economics. If you have a tidy sum in a checking account that doesn't pay interest, you are suffering the opportunity cost of foregone interest that could be earned on a savings account.
Consider the proposal to send a manned mission to Mars. The cost of such a project would be an unfathomable amount, but we can better understand the real cost in terms of the most desired thing that we must forgo. What would the money buy for health care or education?
Cost/Benefit Analysis
We can take the analysis of the proposed mission to Mars a step further with a cost/benefit analysis. After looking at the money costs and opportunity costs we can consider the benefits and put a monetary value on them, as difficult as that may be. The benefits may include scientific knowledge, technological development, and a psychological boost for our nation.
When we predict costs and benefits, we must factor in risks. What are the chances of cost overruns on the mission to Mars or the chances of the loss of life? What are the chances that the benefits may exceed or fail to meet our estimate?
Marginal Analysis
When our choice is how many of something we should choose, we may use another economic tool. Suppose entrepreneur Jones is considering whether or not to increase his production of widgets. What he needs to do is decide if the added revenue will exceed the added cost. He might be tempted to expect the added revenue to exceed his average cost, but he must think at the margin.
Accounting Costs vs. Economic Costs
Economists have a broader conception of costs than accountants have. Suppose you quit your $50,000 a year job and mortgage your home for a $100,000 loan to buy a "Sure Thing Franchise," which you are assured will bring in big profits. The business requires no capital items, only the franchise and your labor. At the end of the first year your sales are $75,000 and your operating costs are $20,000. Your accounting profit is $55,000. A tidy profit, right? However, your real economic profit is the $55,000 less the interest you could have earned on the $100,000 (implicit interest or opportunity cost of capital), say $5,000 (or the actual interest you paid on your mortgage loan), and less the opportunity cost of your year's labor, say $50,000, since that is what you were earning. So, what is your economic profit? Zero! However, you did earn implicit interest and an implicit salary, and you had the satisfaction of being your own boss.
Early economists had a lot to say about value, but current economists seem to take it for granted. We don't need to know much about value theory, but we should have a practical understanding of value. In economics we must make a clear distinction between value in use (utility) and value in exchange (market value), which is determined by the relationship between supply and demand. Value in exchange is the ratio by which goods exchange, and price is value expressed in the monetary unit. When we have inflation, things increase in price but not in value. Prices go up because the purchasing power of the dollar goes down, but the values of things stay the same, other things being equal (ceteris paribus). We will return to the changing dollar later.
How much is your car "worth?" If is a year old, it is worth a lot less than you paid for it in terms of market value; however, in terms of use value it may be still have a lot of use in it. It depreciates in two ways: 1) physical depreciation and 2) obsolescence, which is increased by model changes.
There are different levels of market value that depend upon the time, effort, or cost of selling. When we buy things for personal use, we usually pay a retail price. If we sell something, we usually want a quick sale without much effort and expense in selling. If we sell a car to a used car dealer, we may get the quick sale price or, if we are lucky, the wholesale market price.
Cost does not necessarily equal value. Suppose I build a very typical house costing $200,000 in an area among very similar $200,000 houses. The cost of replacement of my house may be very close to its market value. If I build a $1 million house in the same area, it will be an over-improvement whose market value will be less than the cost of replacement.
Another concept of value is that value is the present worth of all future benefits. (This is the basis for the income approach to value.) Suppose that an income property will produce an annual net income of $10,000 in perpetuity. We can find the value by capitalizing the income using an appropriate capitalization rate. If we find that cap rate in the market, then the capitalized value will equal the market value of the property. If the rate is 5%, then we divide the annual income by 5% to get the value: $10,000 / 0.05 = $200,000.
Interest is the price paid for the use of capital. Let's review simple and compound interest. A principal sum of $100 bearing interest at 6% per annum simple interest for five years will earn $6 per year or $30 total assuming that we keep withdrawing the interest. The sum of $100 bearing compound interest at 6% compounded monthly (each interest amount is added to principal) will earn $34.88. You might be curious to know how long it would take to double the principal. Just call up the "rule of 72," which says to divide 72 by the given interest rate: 72 / 6 = 12 years. My financial calculator says that it will take 11.6 years, so 12 is indeed the rounded amount.
The concept of interest can be applied to other kinds of returns. For example, it can be applied to timber growth in wood and value. Young trees grow at a rapid rate. In old growth timber mortality normally equals the new growth, so there is no net new growth. Conservationists want to protect old growth forests for many non-economic reasons. From an economic point of view one should cut the trees when the annual increase in value decreases to equal the opportunity cost, which is the rate of return on the next best investment of equal risk, and start a new stand of timber. However, there are other things to consider. For example, special tax treatment from the owner's point of view and preservation of a biological treasure from society's point of view. The question then is how much old growth forests of each type should be conserved and how much cut to start regeneration with rapid growth again.
Suppose that a backward country has sizable oil reserves but doesn't have the capital to exploit it. There is an opportunity cost of holding mineral resources. If they could sell oil, they could invest in something that has a return. Let's say that a barrel of oil today sells for $40 and that it will also sell for $40 ten years from now. What would you give for $40 payable ten years from now? What you need to figure is the present value of $40 payable in 10 years assuming an interest rate of, say, 4%. If we plug those numbers into a financial calculator, the answer will be $27.02. (To check that out, let's assume that we invest $27.02 and receive compound interest at 4% over 10 years. Plug in the numbers, and we find that the future value is indeed $40.) So from an economic point of view resources that don't increase in value should be exploited rather than held, but there are other considerations such as the claim that future generations have on natural resources.
We have had an enormous increase in home prices, and the two main reasons are that interest rates have been so low and that speculators have entered the market. Suppose that a home buyer can afford to make installments of $734 per month. This will carry a $100,000 loan on a 30-year level amortized plan at 8% interest, but at 4% $734 per month will service a loan of $154,000. So the buyer can buy a 54% higher priced home for the same monthly payments.
Almost daily I mute a TV ad for gold as an investment. Suppose you are so pessimistic about our economy that you decide to liquidate your US government bonds and buy gold. To determine if this is a good idea, we must compare the risks, returns, costs, and liquidity. Since gold yields no income, there is a high opportunity cost of holding gold. It is the interest that could be earned on the best alternative investment, which in this case may be US government bonds that you hold. If they yield 3%, that is the opportunity cost of holding gold. One risk in holding gold is the market risk, and it is more than one might expect. To see why, go to Gold Historical Prices. There is also a market risk in bonds. If interest rates generally go up, the price of a bond will go down; however, if they are held to maturity, they will pay the face value. There is a risk of physical loss with both gold and bonds that can be handled with a safety deposit box. In the case of bonds there is a credit risk, but it is very small for US bonds unless the country is indeed going bankrupt. In respect to the liquidity factor it is more difficult to find a reputable dealer and sell gold than it is to sell US government bonds.
Another investment that is an alternative for gold is an unglamorous, old-fashioned FDIC (Federal Deposit Insurance Corporation) insured savings and loan association (or savings bank) account, the common man's investment vehicle. Certificates of deposit from an FDIC insured institution are equivalent to US government bonds with respect to risk (up to $100,000 per account). There is no market risk, but CDs are slightly less liquid since their sale before maturity will result in an interest penalty.
We said that as interest rates go up, the value of bonds go down. (This is the interest risk in holding bonds.) In the financial pages today there is a 5.8% bond maturing in 5 years selling for 107. 971, which is not dollars but rather the percentage that the selling price is of the face value that is $1,000, so the bonds were selling for $1,079.71 each. The interest is $58 per year, so the annual rate of return is $58 / $1,079.41 = 5.37%. However, at maturity we won't get our $1079.41 back; we'll get the face value of $1,000. So the yield to maturity as shown in the paper is 4.596%. To check this rate out go to Bond Calculator and plug in the numbers: Price 107.971, face value $1,000, coupon rate 5.8%, months to maturity 60, tax rates 0% (because we are figuring the rate before taxes). Click "Get your results," being 4.01%, which checks rather closely with the yield in the paper.
Business investments often produce a negative cash flow for a period of time before there is positive cash flow. This makes it difficult to compute the rate of return. You can deal with this by using a discounted cash flow analysis. Suppose you want a 10% return on an investment that will return a negative $10M at the end of the first year (all outgo and no income), $0 the second year, a positive $10M the third year, and $20M the fourth year at which time you can sell the appreciated property for $150M. What are you justified in paying for the property? We first compute the present value of the positive cash flows using 10% (your desired rate of return): $7,513, $13,660, and $102,452 (PV of 150M). The present value of the positive cash flows is $123,645 from which we subtract the PV of the negative cash flow, which is $9,099. So if you want a 10% return, if your projections are realistic, and if you are satisfied with the risk, you are justified in paying $114,526 for the property. For an online financial calculator go to Calculator.
For a good basic understanding of interest go to Interest.
The purchasing power of the dollar changes because of inflation and, much less often, deflation as in The Great Depression. The garden variety of inflation is demand-pull inflation. It is a case of too many dollars chasing too few goods and is usually the price we pay for full employment. However, in the late 1990s we had full employment without much inflation.
Cost-push inflation is the second variety. We experienced this type of inflation in the 1970s resulting mostly from high oil prices. It can also be caused by rising wages. Since we also had a relatively high unemployment rate in the 1970s, what we experienced is known as stagflation, which gets its name from a stagnant economy plus inflation.
I am psychologically unable to buy an ice cream cone (locally costing $2.50 or more) because when I started in high school, we went to the nearby creamery and paid five cents for a good two-scoop cone, which often contained a coupon for a free cone. However, comparing 1936 prices with 2000 prices is like comparing apples and oranges because of the change in the purchasing power of the dollar.
A 2000 price of $2.50 for a cone is 50 times what I paid in 1936. How much of this price difference is real and how much is due to the shriveling dollar? The CPI (Consumer Price Index) in 1936 was 13.9 (1982-84 = 100), and in 2000 it was 172.2. Let's deflate the $2.50 nominal price. We divide the 2000 CPI by the 1936 CPI: 172.2/13.9 = 12.4. Now we calculate the 2000 real price in terms of 1936 dollars: $2.50/12.4 = $0.20. So the real price has only increased 4-fold instead of 50-fold.
When we compare the historical prices of something like cars, for example, we are comparing apples and pears because of the technological and quality changes in cars.
If you are receiving a nominal rate of 2% on your savings and if the inflation rate is 2%, what is the real rate of interest that you are receiving? It is 0%!
Suppose the economy is picking up, and we want to see if prices are also moving up. In this case we should look at one of the three Producer Price Indexes (crude materials, intermediate goods, and finished goods). Inflation would first show up in the prices of crude materials. The PPI used to be called the Wholesale Price Index.
The Gross Domestic Product (GDP) is the total value of all commercial final goods and services domestically produced in a given time period. For you older readers the difference between the GDP and the Gross National Product (GNP), which was the measure of output prior to 1992, is that the GNP measures the total product of American owned firms located anywhere, whereas GDP measures the production in the geographic nation regardless of who owns the firms. Toyota cars built in the US are part of the GDP but not the GNP.
In making comparisons with other nations, we use the GDP per capita. China has a large GDP but a low GDP per capita.
When we compare the GDP for different years, we must adjust for inflation. Instead of using the CPI economists use the GDP Deflator, which is a price index that includes all goods and services.
When we subtract depreciation charged off by businesses from the GDP, we get the Net Domestic Product (NDP).
Every dollar of NDP represent income in terms of wages and salaries, profits, interest, and rent for people, so National Income (NI) equals the NDP minus sales tax.
People are interested in personal income. To compute it, we must subtract from NI corporate taxes, retained earning in corporations, and Social Security taxes. To this we must add Social Security and welfare payments, and net interest payments. What people are really interested in is Disposable Income, which is the remainder after deducting personal taxes. Disposable income equals consumption and savings.
Money is one of man's great inventions. It performs three important jobs for us: 1) medium of exchange that facilitates buying and selling, 2) store of value in savings accounts or under mattresses, and 3) unit of account or agreed upon measure for the price of goods and services. Just what does money include? We might think only of currency (coins and bills), but it also includes deposits. When the Federal Reserve System counts the money supply, they add up M1 (currency and checking deposits) and M2 (M1 plus savings deposits, certificates of deposit (CDs), money market funds, and other deposits). How about credit cards? They extend credit, but credit is not money as some people find out to their chagrin.
You will often see references to the Bretton Woods Agreement of 1944. Following WWII it sought to stabilize the international financial situation by creating a fixed exchange system in which other currencies were tied to the US dollar, which was tied to gold ($35 per oz). Therefore, all other currencies were indirectly tied to gold. The International Monetary Fund was created to manage the system. President Nixon "nixed" the Bretton Woods Agreement in 1971 by announcing that the US would cease buying and selling gold at $35 per ounce. Now most the major currencies have a floating exchange rate, and some currencies are still pegged to the dollar. Money not backed by gold or some other commodity is fiat money (money by decree). The US greenback is backed not by gold but by the full faith and credit of the US. Think of a greenback as a non interest-bearing note that is legal tender.
The exchange rate of the dollar in terms of other currencies not tied to it floats as determined by the foreign-exchange market, which acts like any other market. The Bretton Woods world of international finance was inflexible but stable. Now we have a situation that is flexible but unstable. As an example, in 1997 the currencies of Thailand and other Asian Tigers, who had been enjoying a boom with capital pouring in, were tied to the dollar. The value of the dollar rose substantially, and Thailand decided to cut loose from the dollar and devalue their baht to boost exports. This caused investors to pull their money out of not only Thailand but the other Asian Tigers as well, which caused a severe case of "Asian flu." (Paul Krugman called it "bahtulism.") One example of the reach of this crisis was the crash of Asian demand for US Midwest pork causing hog prices to drop to a 40-year low. The new global economy is a scary one.
Commercial Banks Create Money
Try this sometime: Go to your bank and ask the manager if it's true that his bank creates money. He may tell you in no uncertain terms that every loan is backed by a deposit. He is right, but loans can create money. Let's see how banks increase the M1 money supply: 1) "A" has $1,000 in currency (M1 at this point is $1,000.), 2) "A" deposits the currency in the First National Bank, (The deposit is counted as money, so M1 is still $1,000. The currency goes in the vault becoming part of the bank's reserves and is no longer counted as M1.) 3) The bank loans out $900 to "B." (Ten percent of "A's" deposit is kept as required reserves. So 90% of the deposit is excess reserves that can be loaned out.) 4) "B" deposits the loan proceeds in his account in the bank. Voila! That deposit creates an addition to the M1 money supply of $900. 5) Now bank deposits have grown to $1,900 and excess reserves available for loans amounting to $1,900 less $190 required reserves. So the bank makes another loan of $1,710 and the loan proceeds are deposited. Now M1 is up to $3,610.
How long can this pyramid scheme go on? With a required reserve ratio of 10% each new deposit of $1 can result in an increase of the money supply to 1 / %10 or $10. The bank doesn't get to keep the money created, but it does get to keep the interest earned on it. Makes you want to run out and open the Second National Bank, doesn't it?
Federal Reserve System
The venerable Federal Reserve System is the US's central bank organized in 1913 as an independent agency of the government. It consists of the governing body, which is the Board of Governors, and the policy making committee, which is the Federal Open Market Committee, in Washington, DC, and 12 district Federal Reserve Banks, which are bankers' banks. The Fed has the following functions: 1) controls and regulates federally chartered commercial banks, 2) acts as the lender of last resort for those commercial banks who need to borrow to meet their reserve requirements, 3) holds banks' required reserves except for vault cash, 4) clears checks between banks, 5) issues paper currency (It makes money the old fashioned way: it prints it, but it has an even easier way as we shall see.), and 6) controls the money supply.
Controlling the money supply is a big deal for which the Fed has three tools:
The financial press creates confusion about exactly what the Fed's role is in controlling interest rates. For example, one paper on Jan. 22, 2008, said, "The Fed said it was reducing the federal funds rate --- to 3.5 percent from 4.25 percent." Here is part of what the Fed actually said: "The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3-1/2 percent.---In a related action, the Board of Governors approved a 75-basis-point decrease in the discount rate to 4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Chicago and Minneapolis."
The federal funds rate is not "set" directly by the Fed; it is established in the funds market. The Fed establishes a target for the rate that it hopes to achieve with its open market operations in which it buys and sells bonds to the banks.
We have seen how markets enable trade between two individuals that is beneficial to both. In the case of the aforementioned cavemen one was better (had an absolute advantage) at gathering and the other better at hunting. It is easy to see how both could benefit from trade. However, suppose that one caveman is better at both hunting and gathering. Does "common sense" tell you that there is no basis for trade with the other? Actually, both may benefit by specialization and trade because of the principle of comparative advantage.
To see how this counterintuitive principle works, consider a hypothetical example. Both Indonesia and Thailand produce rice and tea. Can they benefit from specialization and trade? They can if each has a comparative advantage in producing a different product. First, let's look at comparative advantage by comparing assumed resource costs (labor in this case).
Since Indonesia can even produce rice for fewer resources than Thailand, why should Indonesia import rice? Here's the deal: It takes fewer resources to produce tea and then trade for rice than to produce their own rice. Since Thailand's labor requirement for tea is very high compared to rice, they will offer an exchange of rice for tea that Indonesia can't refuse.
Usually economics textbooks explain comparative advantage in terms of opportunity cost.
The notion of comparative advantage gives us a new insight into "competitiveness." Thailand is not competitive with Indonesia in the production of either rice or tea in terms of production efficiency, yet trade between the two countries can be mutually beneficial. A country may not be competitive in anything in terms of absolute advantage, but it can trade if it can find something in which it has comparative advantage, the thing that it is least bad at producing, and then exchange it for the thing that it is the worst at producing.
For another example go to Absolute vs Comparative Advantage.
All trade has costs and benefits. This Thailand/Indonesian trade hurts Indonesian rice growers and Thailand's tea growers, and they will scream for tariff protection. But the social benefits of the trade outweigh the social costs of trade injuries. Indonesia's rice growers may claim that Thailand's producers pay lower wages, but suppose that Thailand gave the rice away. Would it be rational for Indonesia to deny their many consumers from getting free rice simply because it would hurt a relatively few rice growers?
Now let's suppose that Indonesia sells tea to Thailand by undercutting Thai tea prices by paying workers much less that Thai workers receive, but instead of buying rice, Indonesia erects trade barriers preventing imports from Thailand. Indonesia then balances its trade by buying Thai capital assets. There would be no offsetting increase in rice production in Thailand. Thai tea drinkers will benefit by having to spend less for tea that will result in spending more for other things, which will result in some more jobs. On the other hand, many tea producers and workers will lose their livelihood, which will tend to depress wages across the board. It may not be clear what the net effect of this one-way trade will be on the Thai economy, but it is clear that to reap the full benefits of trade, it must be reciprocal trade.
Now let's turn to the US economy. Let's look at the costs and benefits from the importation of cars. It has been a disaster for Detroit and has cost many American jobs that are much needed. The importation hasn't been balanced by US exports, so there is a net loss of jobs. (Fortunately, more and more foreign cars are now assembled in the US.) However, one great benefit from trade is that it offers greater variety for consumers. American consumers have been able to get higher fuel efficiency and better quality as a result of imports; the importation of cars has transformed Detroit. I once drove a late 1970s company car that I called the "gray whale." It was a big, long, clunky, gas-guzzling V-8 with a squishy ride and sloppy handling. Today's American cars, large and small, are much better engineered and designed and better made due in good measure to foreign competition.
As consumers we like low prices resulting from cheap foreign labor. One way to benefit from cheap labor is to buy labor-intensive goods like clothes made in foreign sweatshops. This brings an outcry from compassionate people, but we should look at the sweatshops from their workers' viewpoint. Their alternative may be unemployment or a job that is even worse. American consumers benefit, but American clothing workers are displaced. However, consumer clothing savings will result in more spending for other things that create employment. The question is whether or not the net loss in wages is equal to the consumer benefit.
Generally Americans favor free trade, but when we are put to the test, there is often an outcry for job protection. See Paul Krugman: Divided Over Trade. To read about what NFTA is doing to Mexican farmers go to What Is Wrong with NAFTA.
A big problem is the practice of American producers using cheap foreign labor to cut costs. There are several ways in which this may be done. American agribusiness simply entices the labor to come in by giving jobs to undocumented aliens. American consumers benefit from lower food prices, but employment opportunities are reduced. It is often argued that this doesn't take away many jobs that US workers would accept because they don't like the work or the low wages. In the absence of aliens wages would be increased enough to attract US workers into the fields and processing plants.
A second way for US producers to benefit from cheap foreign labor is to close domestic factories and move the production just across the border into Mexico for the sole purpose of benefiting from much lower labor costs. This industry is called "maquiladora industry." (See Maquiladora Industry and NAFTA.) It started with Mexico's Border Industrialization Program in 1965 after the US stopped the Brozero Program. In order to create more jobs Mexico permitted US companies to bring machinery and materials into Mexico duty free. Finished goods could then be exported out of Mexico and duty would only be paid on the value added by manufacturing. This industry has increased under NAFTA. From an economic point of view it would be better to have the industries on American soil and give Mexicans green cards. The Maquiladora industry is not integrated into the Mexican economy, so it is also a mixed bag for Mexico.
The latest and most controversial way for producers to import cheap labor is by "outsourcing" services. For example, some companies are "sending telephone support jobs" to India. As yet this is a minor trend, and in some cases American companies have brought the work back home. Economists will argue that there is a net social benefit for the US, but a politician can't say this outsourcing is beneficial without risking the loss of his job.
In February, 2004, Gregory Mankiw (the president's chief economic advisor at the time) called outsourcing "just a new way of doing international trade" and said, "More things are tradable than were tradable in the past, and that's a good thing. That doesn't mean there's not dislocations; trade always means there's dislocations. And we need to help workers find jobs and make sure to create jobs here." Most economists would agree with that statement, but it brought howls of outrage from congressional members. For a defense of outsourcing go to The Outsourcing Bogeyman. For the pros and cons of outsourcing go to Economics of Outsourcing. For a strong "con" view go to Outsourcing America: Job Loss and Unemployment.
Job losses in US manufacturing have been painful due to companies moving production to lower cost foreign labor markets and due to technological change. At the same time our US schools are turning out large numbers of unskilled people who need manufacturing jobs. They can't all become hamburger flippers.
Since 1962 the federal government has had a trade adjustment assistance program for helping displaced workers based on the theory that when consumers benefit from trade they should share the benefit with those displaced. This is fair, but it is not clear to me that we need a special program for unemployment limited to trade dislocations. A person unemployed because of trade dislocations is no worse off than one unemployed because of technology, mergers, cyclical down turn, or periodic bouts of corporate massive labor cost-cutting; therefore, there is a case for a more adequate comprehensive unemployment safety net along with effective job retraining and effective job placement programs.
What I would really like to see is the balancing of the importation of cheap labor service or products by exports of American goods or services. Unfortunately we are not producing enough of what foreigners want at acceptable prices.
One of the clearest cases for more free trade is in sugar. Our domestic sugar producers have bought off Congress to keep support prices on domestic sugar and import quotas on imported sugar. According to the GAO this program costs US consumers about $2 billion more a year in higher prices for sugar-rich foods, and the USDA estimates that the subsidies cost the taxpayers $1 billion annually. The high cost of sugar has resulted in the loss of an estimated 10,000 jobs in the sugar using companies. The program keeps poor nations who have a comparative advantage in producing sugar from trading with us except for any small quotas they may have. Sugar is only one of the coddled commodities in the US farm program that drives economists up the wall.
International Finance
We must remember that international trade is a two-way street. When Japanese sell us cars, they receive dollars. What can they do with those dollars? They can buy US goods and services, or US capital assets such as government bonds, stock, or real estate with their dollars. They can also sell their dollars in the foreign exchange market for yen, but ultimately someone has to buy something or invest in something with the dollars.
The foreign purchasers of our US bonds have been "enablers" for our addiction for deficit spending. Our "twin deficits," i.e., our trade deficit and budget deficit, are a worrisome matter, but how worrisome is the trade deficit? For an optimistic answer from a foreign economist, go to The U.S. Balance of payments: widespread misconception and exaggerated worries. To look at the numbers, move down through the page to Table 1: U.S. Balance of Payments for 2002, 2003, and projected 2004.
For another more cautious take on the US trade deficit go to The US Trade Deficit. I think it is fair to say that the US is traveling a dangerous twin deficit road, and there is a serious risk of going into the ditch. A trade deficit of this size can't go on forever, and as the late economist Herbert Stein profoundly said, "If something can't go on forever, it will stop."
The US balance of payments statement consists of these accounts:
-----Basic Balance (surplus or deficit financed by Official Reserves balance)
The "current account balance" that you hear so much about is primarily the trade balance since the other items that it includes are minor. Official US reserves are its holdings of foreign currency. Add up the three accounts, and the sum will always be zero. The reason is that to cover a current account deficit we must either sell foreigners more of our capital assets or dip into our official currency reserves.
To see the data for 2006 organized somewhat differently go to US International Transactions. At the bottom note that the "Balance on current account" (line 77) was minus over $200 billion per quarter! We have become a debtor nation big time!
For a graph showing the recent trend and current figures in the trade balance go to Trade Highlights.
Having just pulled itself out of the Great Depression, the United States committed itself to full employment by the Full Employment Act of 1946 that required the federal government to "promote maximum employment, production, and purchasing power." The policy was more explicitly spelled out in the Full Employment and Balanced Growth Act of 1978 (Humphrey-Hawkins Act). It set an unemployment target of 4% while keeping inflation below 3%, which is a pretty tall order. At the time it was thought that the economy could be "fine-tuned" by pulling the levers of economic policy, but we have learned that was an overly optimistic goal.
A major problem in a capitalistic economy is the business cycle that swings between full employment and recession (or, occasionally, depression). Since the 1930s the recessions have been shallower and shorter, which is probably mostly due to monetary policy moves and the automatic stabilizers such as unemployment insurance. A recession is officially defined as a decrease in real GDP over at least two quarters or six months. (An unofficial definition is that a recession is when you lose your job. A depression is when I lose mine.) From WWII to 1991 the average length of a business cycle was five years (11 months of recession and 50 months of expansion).
Normally there is a trade-off between inflation and unemployment, and this relationship is depicted by the Phillips curve. It makes sense that when the economy heats up and unemployment goes down that there will be upward pressure on wages and prices. However, as noted above, during the 1970s we had both inflation and high unemployment. The joker in that situation was mostly the oil problem. Although the Phillips curve was again bent out of shape in the 1990s when we had a period of low unemployment and low inflation, you won't often win betting against the Phillips curve. In the 1990s we had some lucky breaks such as falling energy prices that held other prices down.
Classical economists following their guru, Adam Smith, oppose government intervention by pulling the economic policy levers. They have faith that market adjustments in wages and prices will eliminate unemployment and inflation. The cornerstone of their thinking is Say's Law that holds that supply creates its own demand by its payments of wages, interest, and rent to consumers. So why didn't supply create adequate demand during the Great Depression of the 1930s?
John Maynard Keynes was the father of macroeconomics and the school of economic thought called Keynesian theory, which is a demand-side theory. During the 1930s he said that effective demand determines the level of employment rather than supply. He said that market-driven economies are unstable, that prices and wages are less responsive than people thought, and that the economy can get stalled at a high level of unemployment. In a depression there is so much loss of confidence that people will not increase spending no matter how much the money supply is increased, i.e., monetary moves don't work. This condition is called a "liquidity trap." So how do you get the economy out of the trap? Pull the levers of government spending, and when the economy overheats, reverse the levers of monetary and fiscal policy.
The theory of the monetarists is also demand-side theory. Monetarists focus attention on the control of the money supply, but the more conservative monetarists object to using the money supply as a policy tool. They simply want to keep the money supply steady and growing only as the economy grows.
If demand is stimulated and there is no increase in supply by adding new capacity, the result will likely be inflation. So, supply-side theory focuses on stimulating investment in capacity, which is required in the long run to improve economic welfare. For investment in capacity to grow we need to keep taxes and regulation under control, and we can also use such tools as the investment tax credit.
Although many economists believe that attention to the supply side is important, the so-called "supply-side economics" was not the creation of professional economists. It is a political ideology that reveres Say's Law, rejects pulling the demand-side levers, and always pushes for tax cuts that they support with the Laffer curve, which says that at some point an increase in taxes will decrease total tax revenues. Of course this is true, but these "supply-siders" always think that we have passed that point on the curve. So they say we need to reduce taxes whether we are in a recession or expansion and whether budget deficits are growing or not because deficits don't matter. Goose capacity and the economy will improve so much that tax revenues will grow enough to wipe out the deficit. The problem is that "supply-side economics" is a faith-based ideology rather than a evidence-based theory. Ronald Reagan made "supply-side economics" a part of conservative Republican ideology. His supply-side policies did not confirm the wisdom of supply-side economics.
Let's look at the two sets of levers that can be pulled in an effort to attain policy goals such as increasing employment or decreasing inflation:
The Fed didn't try to use monetary tools to goose the economy until 1936, and then it wrongly raised the reserve requirements of banks because of their concern that commercial banks might use their high level of reserves to make unsound loans. The move only deepened the depression. This is a good example of "government failure." To read more about the interesting story of the Fed's lessons in monetary policy, go to Early Monetary Policy
Franklin D. Roosevelt is remembered for intentionally trying to "prime the pump" with government projects although he campaigned for a balanced budget and was not consistent in using fiscal policy tools to stimulate the economy.
Regulating the economy with the levers of economic policy is a tricky business. The information that policy makers must use is usually inadequate and dated. Since we have an open economy, we must consider what the policy changes will do to the exchange rate, trade balances, and capital flows. It is difficult to get it right, so there is often government failure. There are fewer risks with the monetary levers in the hands of the independent Fed than with the fiscal levers in the hands of politicians. The Fed doesn't always get it right, and although reducing the money supply can cool the economy with the risk of recession, it is less effective in stimulating the economy. Low interest rates don't help if people don't have the confidence to borrow, spend, build, and produce.
To have an understanding of US economic policy, we need to understand the federal budget. So let's start with the budget process:
For a more complete discussion and for a look at the major components of the budget go to Introduction to the Federal Budget Process. For a lot of data on the budget go to Congressional Budget Office.
There are two things we need to know about the federal budget: 1) Since 1969 the federal budget has been a unified budget that includes all revenues and all spending from all government programs including the trust fund programs such as Social Security program. 2) The budget uses cash flow accounting as opposed to accrual accounting. For example, it does not set up reserves for future liabilities such as Social Security. It also treats capital expenditures the same as current expenses. As we shall see, these features distort the meaning of the budget even though the numbers are accurate. Furthermore, the credibility of a budget depends on the credibility of the proposed revenue and spending numbers. Receipts are often overestimated and spending underestimated. Therefore, if a balanced budget is adopted, which is a rare occurrence, it definitely does not mean that revenues and cash and accrued expenses will be in balance.
We should also understand that mandatory spending accounts for most of the outlay. In 2004 the discretionary spending amounted to only 39% of the budget. This means that there are few opportunities to cut the budget.
We are back to our old habit of running large budget deficits that are piled on to the federal debt. Conservatives once stood for sound money and balanced budgets. Now many of the neo-conservatives believe that Ronald Reagan proved that budget deficits and the debt don't matter. Economists consider several factors. First of all they want to see how much of the spending was for capital improvements that will contribute to future income. Secondly, they are interested in the state of the economy when the deficit was incurred. If the economy is in the ditch, running a cyclical deficit may be sound policy, but if we run a structural deficit (i.e., the economy is near full employment), then we are simply not paying our bills. When we run large deficits in good times, we are less able to increase spending to juice the economy when we have a deep down turn.
In looking at the debt economists check to see what percentage it is of the GDP. In other words, the amount of debt that we can comfortably service depends upon the size of the economy. If the debt is large relative to the economy, it competes for savings and crowds out private investment. The interest paid to service the debt also becomes burdensome. When we also run a large trade deficit, foreigners finance a part of our budget deficit by buying bonds. This is great until they decide they have better places for their money. For more on deficits go to The Budget Deficit: Does it Matter.
Some people down play the debt by saying that we owe the money to ourselves. In the first place, foreigners own about half of the privately held US debt securities. Secondly, just because US citizens own part of the bonds doesn't make the debt any less burdensome.
To see which administrations are responsible for increases in the national debt go to Increases in the National Debt
For information on the Federal debt go to U.S. National Debt Clock. It reports that the debt has been increasing at the rate of $1.43 billion per day since September 29, 2006! To look at the national debt as a percent of GDP, go to National Debt Graph (2007 Budget data).
Since there has been much discussion of the Social Security program, we need to understand its relationship to the budget. All government program revenues and payments are included in the budget. However, Social Security financing is segregated in the budget. SS has a trust fund, and it is currently running a surplus on a cash flow basis. Payments into the fund exceed the benefits paid even without the interest that it earns on government bonds that it holds. This surplus, which is counted in government revenues, understates the real federal budget deficits.
If a corporation has a defined benefits pension plan, it must fund the plan, i.e., put money in a pension fund now to meet that future pension liability. The Social Security program does not use such accrual accounting. The result is that it has an estimated unfunded future liability has been valued at $14 trillion. The government collects SS payroll taxes and pays current benefits. Anything left over goes in the SS trust fund. If we don't make some small changes now, it is often predicted that by about 2020 nothing will be left over and by about 2050 the trust fund will be used up. Then the taxpayers will have to make up the difference or benefits must be reduced. These predictions are based on conservative predictions of economic growth.
Although SS needs some tweaking to meet future obligations, it clearly isn't facing a "crisis," and to say that it is going to go bankrupt is meaningless political rhetoric or pernicious political propaganda, if you prefer. The scheme for permitting people to invest a portion (which would likely grow after the "reformers" get their foot in the door) of their SS taxes in private accounts per se does nothing to fix the SS problem. Depending upon the details of the plan, it could make the SS funding problem worse and create huge additions to the budget deficit. Although SS is currently running a surplus, the plan is essentially on a pay as you go basis: current SS taxes received pay benefits. So SS taxes diverted into private accounts will cause a shortfall available for payment of benefits.
We already have a federally sponsored system of personal accounts, i.e., the 401K and IRA accounts. The purpose of SS was designed to provide a fail-safe basic income for elders. Many people would agree that it is the most successful social program we have ever had! If we convert much of SS to personal accounts, we will have to expand the welfare program to support those elders who made bad investment decisions or who have to retire at the time of a bear market.
If we want higher returns from SS funds, we could do so by having SS Administration gradually invest a portion of the trust funds in stocks representative of the Standard and Poor's 500 index of stocks or some other index. (The SS Administration could set up and operate the fund in the same way as an index mutual fund, which selects stocks by applying rules that do not change. Index funds on average perform well compared to managed funds partly because they don't have pay analysts to select the stocks.) It is important to have a system of stock selection that is insulated from political interference. (Incidentally, index funds such as the Vanguard 500 Index Fund are excellent for small investors who wish to invest in stocks. They provide diversification and keep the investor out of the clutches of broker advisors who look out more for their interests than their investor's interests. Vanguard charges a small maintenance fee on small accounts but not purchase or redemption fees.) For more on SS reform go to Social Security.
For a good discussion of SS and the budget go to Social Security and Medicare Trust Funds and the Federal Budget. Also go to Budget Reform.
The common report card for an economy usually includes four economic criteria: (1) efficiency, (2) equity, (3) growth, and (4) stability.
Economic efficiency is gauged by how well the economy is producing what consumers want and by whether it is producing at the lowest cost and selling at fair prices. Capitalistic economies are efficient in producing much of what consumers want, but how much should we be concerned about how our wants are shaped by a deluge of advertising designed to motivate rather than inform? We have a very competitive economy, but the large producers tend to compete more on advertising than on price. For example, the pharmaceutical industry has a well-earned reputation for price gouging and spending large amounts on marketing including advertising directly to consumers ("Ask your doctor if X is right for you.").
Economic equity relates to how fairly production and wealth is distributed. The market rations scarce resources according to the "golden rule:" Those that have the most "gold" get the most goods. (They also have the most power in our "coin-operated" political system.) The gap between the income and wealth of the well-to-do and the wage earners is astonishingly wide and is widening. See Pulling Apart, a state-by-state analysis of income trends.
The issue of economic growth is whether or not the output per capita is growing at an acceptable pace and in the right sectors. It is possible to have too much growth in some sectors. Private enterprise encourages consumerism, which is rampant in America.
Finally, there is the matter of economic stability. We can ask if growth is steady without unacceptable unemployment and inflation. I experienced the Great Depression of the 1930s in which my father lost his farm. Those were heartbreaking times! Fortunately, a depression hasn't been repeated, but we still have the business cycle that brings on frequent recessions that haven't been bad unless you were one of those losing your job.
Let's take a brief look at a few industries to see how capitalism is performing in the US. Agriculture is a very important sector in our economy. In one respect it has been a stunning production success story. Its efficiency and productivity are legendary, but that's a problem as well a virtue. In the first place, American agriculture using present practices is not sustainable. Our high use of chemical fertilizer and sprays for insects, diseases, and weeds is causing environmental problems. Contamination of groundwater is common. Large-scale animal confinement is causing a big waste disposal problem. Cultivation practices commonly result in too much soil erosion. For more information go to What is Sustainable Agriculture?
The high agricultural productivity also causes price/income problems. With the basic ag commodities small changes in supply result in large changes in price because the quantity demanded is not very responsive to price. So a little overproduction brings a big drop in prices. If potatoes, for example, are your basic starch, will you buy any more potatoes if the price goes down by 20% or any less if it goes up 20%? A large national crop of russet potatoes can actually sell for less total revenue than a small crop! Economists call this an inelastic demand.
Every since the 1930s the politically powerful agricultural interest groups have been able to get one farm program after another to try to improve their economic position. The latest is the Farm Security and Rural Investment Act of 2002. To read what one analyst has to say about the Act, go to The Farm Bill is a Bad Joke with a Good Punch Line.
Now let's turn to the food processing and marketing industry. Our nation is having an obesity epidemic with all of its collateral health problems. Part of the problem is poor consumer education, but the principal problem is the poor performance of the food processors. Their products tend to be loaded with fat, sugars, and polysyllabic food additives, and their advertising tends to be loaded with misleading claims, to say the least. If you would like to see all of this spelled out, obtain Dr. Marion Nestle's book, What to Eat, (2006).
What nice thing can we say about the fast food industry? We can say that it provides a lot of jobs for our hoardes of poorly educated young people. On the other hand fast food is a big problem for the health of Americans. Hot dogs, hamburgers, and French fries, all of which I enjoy on very rare occasions, should have cigarette-type health warnings on them. For a detailed indictment go to Fast Food Nation.
Our health care "system" is mostly private, and it provides some of the best medical treatment in the world for those who can pay for it. Preventive medicine and health education are terribly deficient. The system has served me very well since I have always had good but declining employer health insurance coverage. Poor people get a significant portion of their care in emergency rooms. Many of those who are covered with health insurance are in a constant hassle with insurers who try to limit their liability. Our health insurance is mostly employer-based, which drives up our manufacturing costs helping to make us uncompetitive in world markets. To see what Americans think of their health care system go to Health Care Pains.
The inefficiencies of health insurance system make it much more expensive than a single-payer system, which we can't have because that would be "socialized medicine." However, we seniors already have a good, efficient single-payer system: Medicare.
When was the last time you read a good word about the pharmaceutical industry, the most profitable industry of all? For a brief summary of the case against the industry go to An Industry Under Fire.
Turning to efforts to privatize education, Edison Schools Inc., a private company, is the nation's largest private manager of public schools. How is it doing? Its academic performance is a mixed bag. (See, for example, Inside Edison's Schools.) Financially, Edison's stock had tanked when it went private and then was sold to the Florida Retirement System, which paid $112 million and also loaned the company $70 million. There are two ironies in this story. One is that the management of a pension fund would make such a highly risky investment. The second and biggest irony is that about half of the people in the pension fund are teachers who hate the idea of privatizing schools, hate Edison, and had no voice in the decision. For the complete story go to How Edison Survived. This is not a pretty story!
The auto industry is one of our major manufacturing industries. At a time when we would like to become more energy independent, when we should be concerned about fuel efficiency, when we are concerned about air pollution and global warming, and when we are concerned about auto safety, what kind of vehicles has the industry been pouring out? SUVs! One can say that foreign competition forced Detroit to vastly improve quality and design and that regulation and competition has resulted in greatly improved safety. So how is the economic health of the industry? Not good! As this is written GM, Ford, and the Chrysler Group of Daimler Chrysler are all dripping with red ink.
Now let's take a look at the airline industry. In much of my traveling days it was a heavily regulated industry. The airline companies were generally in good financial condition. The service was good, the food was excellent, and the fares were high. Then Alfred Kahn, my professor of economic policy at Cornell, spearheaded the deregulation of the airlines when he was chairman of the Civil Aeronautics Board from 1977 to 1978. The good outcome was a drop in fares, which are now too low because one airline after another has been in or on the edge of bankruptcy.
What about the performance of the media industries? The trend there since the Telecommunications Act of 1996 has been toward concentration of ownership. For more about this situation go to Concentration of Media Ownership. Another troubling problem results from the FCC killing the fairness doctrine. In 1961 speech FCC chairman Newton Minnow assured his listeners that if they kept their eyes glued to their television screen, "I can assure you that you will observe a vast wasteland." The only thing that has changed since 1961 is that the vast wasteland has become raunchy as well as more politically biased. One of the few small oases in the desert is PBS.
In 2007 the economy started sliding downhill, and the major culprits were many participants in the mortgage credit industry who eschewed sound business and ethical standards for the sake of profit. Wall Street started a new Ponzi game. Investment banks or bundlers found big profits in buying mortgage loans and slicing and dicing them into high-yielding, high risk derivative securities that were given an obliging nod by the lawyers, over-rated by obliging ratings firms, and over-recommended by bond brokers. Since the junk securities were gobbled up by investors, the bundlers wanted more mortgages whether sound or not. In response local mortgage brokers looked for more borrowers whether credit-worthy or not, appraisers obligingly overvalued properties, and primary lenders didn't enforce prudent credit standards because the loans were made to sell at a profit rather than to hold. Well, finally the inevitable happened: the bubble burst. Interest rates on adjustable loan started rising, loans started defaulting in large numbers, derivative securities started tanking, and loan foreclosures started increasing dramatically. Everyone profited except the naive people who invested in the junk securities, a lot of people who lost their homes and any equity that they had in them, and a lot of innocent bystanders such as home builders and their work forces.
Here is a good example of market failure and also government failure. The market failed because actors in the market had either improper incentives or inadequate information to act prudently. The government failed because of an ideological bias against regulation and because of incompetence. The Fed kept interest rates too low for too long contributing to a housing boom, and Treasury didn't assume its responsibilities. Congress didn't investigate and re-regulate financial institutions when the handwriting was on the wall. It wasn't as if the sub-prime loan debacle was an unpredictable outcome. Twenty-five years ago Hyman P. Minsky spelled out the broad outlines of the Minsky Credit Cycle, which has five stages: displacement (a new exciting financial gimmick or situation arises), boom, euphoria, profit taking, and panic. Surely we have learned a lesson about the need to regulate financial markets. But isn't this a replay of sorts of the savings and loan crisis not too many years ago?
So what grade should we give the performance of our major industries as a group? Markets simply don't work well unless there are proper incentives and adequate information available to all. The government must encourage proper incentives and require adequate information in the markets if we are to have optimal efficiency, equity, growth, and stability in our economy.
If a chemist has a eureka moment producing an innovative hypothesis, he can rush off to his lab and test it. He can change one variable at a time while holding all other variables constant. An economist can seldom perform an experiment to test his hypothesis. He is left with two options. The first is to find and analyze relevant empirical data (real world data) showing what happened. Since there are so many factors involved in economic movements, it is difficult to tease out the effect of a single factor.
The complexity of the economy has driven economists to the second option: the use of simplified models of reality. These models may express relationships in words, graphs, or equations. The problem of modeling our complex economy is about like that of modeling our weather system, and the accuracy is about same.
One of the reasons that economic predictions vary so widely is that the economists may be using different economic models or using different assumptions.
Choose an online economics book:
Bureau of the Census
Bureau of Economic Analysis
Bureau of Labor Statistics
Congressional Budget Office
Federal Reserve System
Other
I welcome feedback. Please send an e-mail message to me, Bob Parvin: bandcparvinXhotmail.com (Substitute @ for X. I'm trying to hide my address from spammers.)
Copyright (c) 2005 Robert G. Parvin.
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By producing what they are best at or least worst at and trading both countries can enjoy more tea and more rice if they can agree on the terms of trade.
Current Account
-----Trade balance
-----Current account balance (1 through 8)Capital Account
-----Capital account balanceOfficial Reserve Transactions Account
-----Official reserves balance
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Whitehouse
