Текст книги "101 Things Everyone Should Know about Economics: From Securities and Derivatives to Interest Rates and Hedge Funds, the Basics of Economics and What They Mean for You"

Автор книги: Peter Sander

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CHAPTER 2

Economy and Economic Cycles

We start with the economy. Not a big surprise in a book titled 101 Things Everyone Should Know about Economics. By way of definition, the economy is a system to allocate scarce resources to provide the things we need. That system includes the production, distribution, consumption, and exchange of goods and services. It is about what we do as a society to support ourselves, and about how we exchange what we do to take advantage of our skills, land, labor, and capital.

Of course, that definition is a bit oversimplified. The economy is really a fabulously complicated mechanism that hums along at high speed—the speed of light with today’s technology—to facilitate production and consumption. The economy itself is fairly abstract, but touches us as individuals with things like income, consumption, savings, and investments, or more concretely, with money, food, cars, fuel, and savings for college.

One could only wish ours was a “steady state” economy—that it would always provide exactly what we need when we needed it. Unfortunately, it isn’t so simple. The economy is directly influenced by a huge, disconnected aggregation of individual decisions. There is no “central” planning for the economy (yes, it’s been tried, but doesn’t work for a variety of reasons), although governments, central banks, and other economic authorities can influence its direction. Because the economy functions on millions of small decisions, the economy is subject to error—overproduction and overconsumption, for example. Take these errors, add in a few unforeseen events, and the result is that economies go through cycles of strength and weakness.

The first fifteen entries describe the economy, economic cycles, economic results, and some of the measures economists use to measure economic activity.

1. INCOME

Income is the money we receive in order to buy what we need when we need it. Economists look at income in several different ways—including where it comes from, how much is earned, and how much of what is earned can really be spent. Income includes the following money flows: wages to labor, profit to businesses and enterprise, interest to capital, and rent to land.

What You Should Know

Income is what people earn through either direct labor or as owners of investments. The amount of income we earn as individuals and families connects to the economy’s prosperity and strength. It dictates how much we can ultimately spend and the value we bring to the economy as a whole. The amount of income earned collectively as a country determines the economic health of a nation and of groups within it.

Economists look at national income (covered further under #4 GDP), per capita income (income generated per person), and household income (how much income is generated by the average household). In all but the worst times, incomes should rise as people accomplish more by becoming more skilled and productive at their jobs and in their businesses. Economists also speak of real income increases—that is, increases adjusted for inflation, as opposed to nominal increases, which represent the raw numbers but not necessarily true income growth.

Economists also consider disposable income, or the amount of income actually available for individuals and families to spend after taxes. Disposable income is a truer indicator of how much purchasing power we really have, and how much of that purchasing power will ultimately be available to drive the economy and create more income.

The Census Bureau measures income annually through the American Community Survey. Income figures are published in the financial press and can be seen in greater detail on the U.S. Census Bureau’s website: www.census.gov/hhes/www/income/income.html.

You can see how income is distributed among different population groups or states, as well as overall income growth. The annual press release will contain statements like: “Real median household income in the United States declined by 1.5 percent between 2010 and 2011, reaching $50,054.” The decline in median household incomes—some 8.1 percent since 2007—has been persistent, and is one of the reasons that our leaders are so concerned about the economy these days.

Why You Should Care

Most of you probably care more about your personal income than that of the nation or others around you! Your own income ultimately determines your purchasing power and is a key factor in your overall quality of life. If your income isn’t increasing—or worse, if it is decreasing—you know that’s not a good thing, and you might have to adjust your way of life.

Watching published income figures helps you keep tabs on the ups and downs of the economy. By itself that may or may not interest you, depending on your profession or general level of interest in national success. However, if you track national, household, and per capita income changes and compare them with your own, you can see whether you’re gaining or losing ground.

Income changes can also be useful as a measuring stick for other economic factors, like growth in asset prices. During the real estate boom, for example, home prices far outpaced gains in income. Smart economists knew this couldn’t last forever. Either incomes had to rise (to keep pace) or home prices had to stabilize or fall (to allow incomes to catch up). So watching gains in income can be a good test to make sure other economic changes make sense.

See also: #2 Consumption, #4 Gross Domestic Product (GDP), and #14 Distribution of Income and Wealth.

2. CONSUMPTION

Quite simply, consumption is what we, in aggregate, consume. And like income, the measurement of consumption at a national level helps us understand whether the economy is getting weaker or stronger. As an individual, you have more control over consumption than income, so it’s important to monitor your consumption to be certain you can make ends meet.

What You Should Know

Economists track personal consumption expenditures (PCE). As the term implies, PCE represents funds spent on goods and services for individual consumption. “Goods” breaks down into durable goods—goods expected to have a useful life greater than three years, like cars and lawnmowers—and nondurable goods like food, paper products, cleaning supplies, and so forth. Personal consumption expenditures exist in addition to private business investment, providing goods and services for export, and government consumption of goods and services.

The Bureau of Economic Analysis (www.bea.gov) monitors and publishes PCE reports; the Bureau of Labor Statistics (www.bls.gov) gives longer histories and projections for PCE. Since consumption accounts for some 71 percent of the total U.S. economy, a small change in PCE can signal a big change in prosperity ahead.

Why You Should Care

At a national level, during the boom years prior to the Great Recession, low interest rates, easy credit, and low-cost imported goods combined to cause a consumption bubble of massive proportions; the Great Recession was in part an unwinding of that bubble. Savings rates (covered in the next entry) went from negative to moderately positive as consumers became more conservative. This caution has brought consumption back to more sustainable levels—that is, somewhat less than income and more in line with income growth.

That’s a good thing on a national basis. The key for you as an individual is to make sure your own PCE is in line with your income and income growth. And if you’re an investor, monthly PCE reports can give you an insight to where the economy is headed.

3. SAVING AND INVESTMENT

The personal saving rate is defined, very simply, as the percent of personal income that is not consumed. In specific economic terms, it is personal disposable income minus personal consumption expenditures. In real-world terms, it’s money you don’t spend today but instead put aside to spend tomorrow.

Investment, on the other hand, is an allocation of goods or capital not to be used just for current but also future production. Over time, when an economy is in balance, saving should equal investment; that is, the money, or wealth, put aside should be invested, or used, for future consumption.

Granted, that sounds a bit complicated and theoretical. As a practical matter, it’s more interesting to look at saving as it has really occurred over time. It’s also more interesting to think about how saving and investment should occur in your own household.

What You Should Know

First, it’s important to distinguish “saving” from “savings.” Saving is the setting aside of surplus funds—that is, what you don’t spend. Savings refers to the actual accounts, like your savings accounts, in which you do it. The level of “saving,” not “savings,” is what’s really important for you and for the economy as a whole.

Consumer saving, until recently, had been on the skids for quite some time. For many years we were a nation of savers: in the 1960s saving was 6 to 10 percent of income, and rose to a level as high as 14 percent briefly in the recessionary period of 1975 (yes, saving rises during economic hardship; see #35 Paradox of Thrift).

In the late 1970s, saving rates started to decline because of high inflation rates—people needed more of their income to meet expenses and came to expect the purchasing power of their savings to diminish. Saving rates fell back to the 8 to 10 percent range, still healthy by today’s standards. The 1982 recession increased it to 12 percent; that peak foreshadowed a long, slow decline into the 6 to 8 percent range by the late 1980s, down to 2 percent in the late 1990s, and hitting negative territory by 2005. It has hovered near zero since then; however, in the aftermath of the Great Recession, the savings rate rose to about 5 percent, as people feared for their jobs and incomes, and has settled a bit to the 3 percent range. That sudden return to saving, ironically, hampered the recovery (see #35 Paradox of Thrift).

Why You Should Care

Until the Great Recession hit, most Americans fell into a trap of increased consumption, the prioritization of “now” over the future. We felt the “wealth effect” (see #15) of higher house prices, cheaper goods mainly from China, stable incomes, and strong marketing messages. Saving took a back seat, despite dire warnings about the future of Social Security and retirement. The combination of weak income growth, unemployment, and asset price declines brought a sudden end to the party. The message, of course: prudent Americans should choose the path of sustained wealth, placing savings as first priority and buying only what we can afford. You should invest those savings for returns in the future, as should society as a whole.

4. GROSS DOMESTIC PRODUCT (GDP)

Gross domestic product is the sum total of all goods and services produced in an economy. As it measures the market value of all final goods and services produced by a nation, it is a fundamental indicator of an economy’s performance. It is highly correlated with personal incomes and standard of living. It can be looked at as a true measure of the value added by an economy.

What You Should Know

The calculation of GDP boils down to a sum of four items: Personal consumption plus total personal and business investment plus public or government consumption plus net exports (exports minus imports). It is thus a measure of what is consumed today (consumption) plus what is put aside for tomorrow (investment) plus our net sales to others around the world. That combined figure in turn roughly represents the income we as a nation produce from all of those activities.

Economists track both the size and the change in GDP. The U.S. GDP in 2012 was just over $14.5 trillion, but with the effects of the Great Recession, the average annual growth rate dropped from 3.2 percent (1997–2007) to an average of 0.7 percent from 2005 to 2010. More recently, it has returned to a still rather anemic 1.5 to 2 percent. GDP dropped 6.3 percent in the fourth quarter of 2008, one of the sharpest declines on record, and a true measure of the severity of the Great Recession. At that time it should be noted that other economies fared worse—Germany’s GDP went down 14.4 percent, Japan’s 15.2 percent, and Mexico’s declined by 21.5 percent in the same period. However, their base GDPs are much smaller, so the value lost in the decline was less.

The breakdown of U.S. GDP components (from 2012) is also interesting:

Personal consumption

71%

Personal and business investment

15%

Public, or government, consumption

17%

Exports

13%

Imports

−16%

The good news is that exports have increased about 2 percent since 2008, while imports dropped about 1 percent (influenced in a large measure by reduced dependence on foreign oil). Also, the public/government consumption share has declined about 2 percent, signaling less reliance on that sector. But dependence on consumption still remains high, as the following figures for China will show:

Personal consumption

35%

Personal and business investment

48%

Public, or government consumption

13%

Exports

30%

Imports

−26%

China, in contrast to the United States, is foregoing current consumption to build for the future, although the trade balance has shifted about 5 percent away from exports and toward imports—perhaps bad for China, but good for the rest of the world.

The GDP is also an important measure of standard of living. Economists measure GDP per capita—that is, per person in a nation. Here, the U.S. at $47,150 (World Bank figure from 2012) is on solid footing, although not at the top of the pack (twelve nations, including Norway, Denmark, Australia, and Qatar, are ahead on this measure). As well, economic wealth isn’t the only component of standard of living; the less measurable safety, health, leisure time, and climate go beyond GDP per capita as components of true living standards (though these are sometimes separated out as components of quality of living).

Why You Should Care

The GDP is the broadest measure of the country’s overall economic health, and it defines the economic “pie” you ultimately enjoy a slice of. If it is healthy and growing, times are good; if it is stagnant or declining, it will most likely affect your standard of living, sooner or later.

5. UNEMPLOYMENT AND UNEMPLOYMENT RATES

Most of you have a good idea of what unemployment is—especially when you don’t have a job! Economists take the same view, but add the conditions that unemployed people are not only without a job but are also available to work and are actively seeking employment. The unemployment rate is the percentage of the work force that is currently out of a job and is unable to find one, but is actively looking.

What You Should Know

Economists closely watch the unemployment rate as a signal of overall economic health. High unemployment is a sign that an economy is weak currently and will remain so. Why? Obviously, if people are losing jobs, demand is most likely falling, as are incomes and purchasing power. When people lose jobs, they can afford less, home foreclosures rise, they can save less for retirement, and their future becomes more grim in general.

Economists also recognize that there is no such thing as a true, 100 percent, full-employment economy. Some unemployment is structural; that is, created by changing job requirements—there simply aren’t as many jobs for autoworkers or office clerks these days. Some is frictional, caused by the natural changes businesses make and that people make to their lives, moving from one place to another. Some is seasonal, the result of a decline in certain jobs that are tied to particular times of the year (for example, sales clerks in retail stores during the Christmas holidays). As a result, economists suggest that an unemployment rate of about 4 percent represents “full employment.”

As you can see from Figure 2.1, unemployment rates reached an all-time low during World War II and a substantial all-time high in 1933. The numbers for that year were astounding: 25 percent overall for the work force; 37 percent for nonfarm workers (see #6 Recessions and #7 Depressions). Aside from those periods, the unemployment rate in good times decreases to about 4 percent and surges toward 10 percent in recessions, including 1982 and the most recent in 2009. More recently, unemployment rates have ticked back downward to the mid-7 percent range. Typically, when unemployment rates exceed 7 percent or so, governments go into action to stimulate the economy (see #58 Chicago or Monetarist School, and #57 Keynesian School).

Figure 2.1 U.S. Unemployment Rates, 1890–2011

Source: Bureau of Labor Statistics

Why You Should Care

Obviously, when unemployment is on the rise, it suggests a reduction in business activity, which means you should be more fearful for your job as well. You should do whatever you can to make yourself more employable, including building new skills or becoming more indispensable on your job, by building expertise and credibility within your own organization. You should also develop contingency plans, including savings cushions and prospects for perhaps doing your job as an independent contractor. Long-term employment with big companies still happens, but is less the norm than ten or twenty years ago; it has become more of a “free agent” economy, and you should hold nothing back in becoming part of it. Aside from keeping an eye on the unemployment rate in order to protect your job, it’s a smart way to monitor the pulse of the economy, which will affect your investments, your company if you’re a small-business owner, and your tax revenues if you’re in the public sector.

6. RECESSIONS

The U.S. National Bureau of Economic Research defines a recession as a period with “a significant decline in economic activity spread across the country, lasting more than a few months, normally visible in real GDP growth, real personal income, employment (nonfarm payrolls), industrial production, and wholesale-retail sales.” During that time business profits typically decline as well. As a result, public-sector tax revenue also falls.

What You Should Know

Many call it a recession simply when a country’s GDP declines two calendar quarters in a row, or when the unemployment rate rises 1.5 percent in less than twelve months.

Technical definitions aside, perhaps Harry Truman had the best definition of a recession, and how it differs from a depression: “It’s a recession when your neighbor loses his job; it’s a depression when you lose yours.”

Recessions can be notoriously hard to forecast. For instance, how many really predicted the Great Recession, and especially its severity? When things are going well, we tend to become complacent, even optimistic, about the idea that anything can go wrong. We’ve grown accustomed to federal government intervention to prevent recessions by lowering interest rates and taking other measures to stimulate the economy (see #8 Business Cycle). Even the markets can’t tell us much; as economist Paul Samuelson famously stated: “The stock market has forecasted nine of the last five recessions.”

The National Bureau of Economic Research, the U.S. government organization generally responsible for identifying recessions, has noted ten recessions since World War II. As you can see from the table, recessions are generally short in duration—lasting less than a year—and typically happen about twice a decade.

The most recent of these, the so-called Great Recession, was also the largest since World War II, with a drop in GDP from peak to trough of 5.1 percent. By contrast, from August 1929 through March 1933, during the Great Depression, the GDP dropped 26.7 percent—hence “Depression” instead of “Recession.”

Table 2.1 U.S. Recessions 1945–2012

Occurrence

Duration

November 1948–October 1949

11 months

July 1953–May 1954

10 months

August 1957–April 1958

8 months

April 1960–February 1961

10 months

December 1969–November 1970

11 months

November 1973–March 1975

16 months

January 1980–July 1980

6 months

July 1981–November 1982

16 months

July 1990–March 1991

8 months

March 2001–November 2001

8 months

December 2007–June 2009

18 months

Source: U.S. Bureau of Economic Research

Why You Should Care

Recessions mean less for everybody, and unless you have a pile of money or are in a business largely immune to downturns, you should prepare to make adjustments when recession clouds start to gather. Warning signs include changes in the employment rate, an excess of debt, or “irrational exuberance” in some or all markets (like dot-com stocks in 2000 and real estate in 2006). You should learn to recognize when times are good, and use those times to save some money.

You should also watch to make sure your standard of living is matched to the worst, not to the best, of times. In good times, avoid allowing your lifestyle to consume all of your income, and worse, to put you into debt. If you do, you’ll have the flexibility to get through the bad times.

7. DEPRESSIONS

In economics, a depression is a sharp, protracted, and sustained downturn in economic activity, usually crossing borders as a worldwide event. It is more severe, and usually longer, than a recession, which is seen as a more-or-less normal feature of the business cycle (see #8 Business Cycle).

Depressions are usually associated with large collapses in business, bankruptcies, sharply reduced trade, very large increases in unemployment, failures in the banking and credit system, and a general crisis mentality and panic among the population, big corporations, and policymakers. Depressions can cause severe economic dislocations, including deflation (see #19 Deflation) and the wholesale demise of certain industries.

Of course, the Great Depression is the granddaddy of all depressions, lasting, by most accounts, from the 1929 stock market crash, which triggered subsequent banking failures and spread to the larger economy, all the way to World War II.

What You Should Know

To give an idea of the severity of depressions, the unemployment rate during the Great Depression went from 3 percent in 1929 to 25 percent in 1933 (37 percent for nonfarm workers). In some cities with a large factory base, it rose as high as 80 percent.

The good news is that depressions don’t happen often. As of 2012, there have only been three “depression” events in U.S. history: the Great Depression in the 1930s and two less severe panics in 1837 and 1873.

A long and large economic expansion that turned into a speculative bubble fueled by borrowing and debt preceded all three depressions. Those who borrow too much fail first, as they cannot service their debt, and that causes a rise in bankruptcies and asset prices to fall, leading to a vicious circle of debt-unwinding known as deleveraging (see #9 Deleveraging).

The challenge of the government is to intervene effectively to help out the economy. The Great Depression led to a significant banking panic. As banks failed, the government adopted a “laissez-faire” mentality, letting weaker elements be flushed from the system. This approach is good in theory, but it accelerated the panic. A misguided attempt to protect American business through trade tariffs failed miserably and made the problem worse.

Government may intervene, but history shows it has yet to do so effectively. By the time the U.S. government stepped in, it was too late; markets and businesses starved first for credit and then for customers had shut down. The government started stimulus programs to put people to work, moved away from the gold standard, devalued the dollar to make U.S. goods more competitive internationally, and passed legislation to protect the public from such calamities in the future. It was a very long and rocky ten years.

Why You Should Care

The Great Recession had some of the earmarks of a depression in the making, with severe stress on the banking and credit system and sharp rises in unemployment. But the many safeguards, like deposit insurance, Social Security, unemployment insurance (see these entries in Chapter 5), and various other forms of government intervention made a downturn of 1930s proportions seem unlikely. That said, you, as a person in charge of your finances, must always recognize the possibility—not probability but possibility—that such an event could occur, and keep your finances protected against such a downturn.

8. BUSINESS CYCLE

The term “business cycle” describes a more-or-less normal flow of American and world business activity over time from strength to weakness and back to strength. “Boom” conditions describe strong business growth throughout the economy, while a “bust” occurs when the economy gets tired, or some intervening event occurs that sends the tide the other way. Booms and busts have occurred throughout economic history, and naturally, one follows the other, but their pattern isn’t identical or predictable.

What You Should Know

Business cycles are natural and unavoidable, and arise out of the normal course of business. Government policy can smooth them or help them along, but it can’t create or prevent them. Cycles arise from two primary factors: the imperfection of information and the evolution of technology and tastes.

Imperfection of information refers to the fact that business leaders don’t have perfect information when they make decisions; they make too much, sell too little, and spend too much because they don’t have perfect crystal balls. The evolution of tastes and technology, a constant through history but occurring ever faster, creates new markets and eliminates old ones.

These two elements cause businesses to overshoot, overcorrect, and otherwise make flawed decisions. In a boom, that can lead to overproduction and the assumption of excess debt and risk—which then leads to a bust. The business contraction that follows eventually reduces supply, cleans up excess debt, and starts business over with a clean slate toward another boom. Through increased spending and lowered interest rates, government policy helps the process along. Business cycles bring new things and clean old, obsolete businesses off the economic floor.

As William Poole, former Federal Reserve Bank of St. Louis chairman, eloquently put it: “The world we live in is uncertain and cyclical because the U.S. economy is dynamic, inventive, experimental, and entrepreneurial. Some ideas are carried to excess, we discover after the fact. Look at the littered landscape of dead railroads, dead auto companies, and dead airlines to illustrate the point.”

Why You Should Care

Booms and busts are a natural part of your financial life. If you have a steady job, you might not have to worry too much, but it’s always good to be aware of what’s going on and how it might affect your behavior and your finances. People tend to become “giddy” during booms, taking on more risk without realizing they’re doing so (as in buying overpriced homes, no money down, during the real estate boom). To keep from getting in over your head financially, you should always tune your finances to the bust; then the boom will feel that much better.

9. DELEVERAGING

Deleveraging refers to the tendency for individuals and corporations to get rid of debt in a forced, untimely manner during a bust cycle, or recession. It is the opposite of adding leverage—that is, borrowing more and using those funds to buy assets, where perhaps one dollar of your own is matched to nine borrowed dollars to buy something worth ten dollars. The 9:1 leverage ratio is nice, so long as the asset continues to be worth ten dollars or more, but the first dollar lost is your dollar if asset prices go down. To deleverage, you would pay off your nine-dollar debt as quickly as possible to reduce your risk of loss.

What You Should Know

Desperate to repair the damage inflicted on their balance sheets by debt, financial institutions will sell assets during a deleveraging cycle. When they sell assets, guess what? Prices go down. That actually makes it worse, starting a vicious circle as forced sales push asset prices down further. This then spreads to more companies, more individuals, more balance sheets. Soon the government is left with the only balance sheet strong enough to keep buying.

The deleveraging that hit in late 2008 was severe and was a major contributor to the Great Recession. Banks laden with mortgage-backed securities were forced to sell them to make good on deposits by their customers; that selling process further cut the value of those securities, which were nearly impossible to value in the first place. As stock prices fell, hedge funds (see #72 Hedge Fund) were caught flatfooted by investors requiring redemptions, since the funds were borrowing money to juice their returns. Therefore, the hedge funds were forced to sell assets to meet those redemptions and pay down debt. That made stock prices fall faster than they otherwise would have.

Why You Should Care

The point is to never get into a situation where you have to pay back debt in a panic. The assets you borrowed to buy will be worth less, and it will be that much harder to raise the money you need to pay off the debt. Best place to be: no debt at all. If you have debt, it should be only in assets you would be unlikely to sell in most situations (for example, your house), and with interest and principal payments well within your budget even in tougher times

10. MISERY INDEX

Sometimes it helps to put the economic data you see, hear, and read about together and in context with a single indicator or two. It’s like taking all the weather data—temperature, humidity, precipitation probability, wind speed—and coming up with “it’s going to be a nice day.” Or, in this case, a bad day.

Some years ago, the economist Arthur Okun did this for us by creating a “misery index.” By adding together the inflation rate (see #18 Inflation) and the unemployment rate (see #5 Unemployment and Unemployment Rates), you arrive at the misery index.

What You Should Know