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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19. DEFLATION

If inflation is bad, doesn’t that mean that deflation is a good thing? It sure would seem that a decline in the prices of goods and services would be good; our money would be worth more, and we’d all be able to buy more for our money. What’s wrong with this picture?

What You Should Know

Actually, economists hate deflation, which is defined as a sustained, across-the-board decrease in prices, a negative inflation rate. Why? Because, quite simply, if people perceive that prices will go down, they’ll stop spending and wait for those prices to go down further. Businesses will do the same thing. Furthermore, businesses won’t be able to sell their products for as much money in the future, and are using relatively more expensively priced materials and labor they have to buy today to produce them in advance of that sale. So for the business, profits suffer; for everybody, the slowdown caused by people hoarding money anticipating it will become worth more later ends up sapping the economy.

Reduced consumer and business spending can cause a severe business slump; in fact, deflation is typically only observed during the most severe business crises, including the Great Depression and the so-called “lost decade” in Japan that started in the 1990s. In Japan, a large inflationary bubble driven by real estate and irresponsible lending unwound. Prices started to drop and banks stopped lending, starting a downward spiral of decreased consumption and spending that didn’t let up until recently, when the central Bank of Japan took rather drastic measures—that is, printing lots of money—to artificially decrease the value of the yen and rekindle mild inflation.

The good news is that we haven’t really seen deflation lately, although there was a persistent threat of it as a consequence of the Great Recession. Figure 3.1 illustrates the fact that deflation occurred considerably more often in the past.

Why You Should Care

For most individuals, deflation isn’t that scary, unless it is prolonged and leads to an extended business slump. That, of course, means a more severe contraction of business, and additional job losses. The bigger problem can be the actions of central banks like the Fed, which go so far to avoid deflation, they end up sowing seeds of a stronger inflation. That was the big worry in the wake of the Great Recession. Bottom line: the less you hear about deflation, the better.

20. STAGFLATION

As the name implies, stagflation is a painful combination of inflation and economic malaise. Since the “typical” cause of inflation is excessive demand in an overheated economy, the combination is a bit surprising for economic purists. But the occurrence of both together happened in a big way in the late 1970s, when high inflation was accompanied by high unemployment, and it continues to be a threat to the current economy both in the United States and abroad (see #10 Misery Index).

What You Should Know

Stagflation generally has two causes. One is a supply shock, as in the oil shocks in the late 1970s, and to a degree, the oil price spike in 2008. Inflation is caused more by supply factors than general demand, and so the traditional means of fighting inflation through monetary policy (reducing money supply, raising interest rates) don’t work—they only serve to slow the economy while not solving the supply shortage. Stagflation can also be caused by excessive regulation, or by other practices that make economies inefficient, combined with inflationary monetary policy. Such has been the case in Europe and Latin America from time to time.

Why You Should Care

For the U.S. consumer, the sort of stagflation caused by oil shocks or similar shortages creates the most concern. If you see inflation in the economy, particularly energy and food prices, that should not be taken as signs of a robust economy; more likely, the economy will sink as higher prices sap the strength, like a tax, of the economy. If the government tries to deal with these effects by tightening the money supply, look out—especially if you’re in an economically sensitive vocation.

The good news: the sort of stagflation caused by regulation or economic inefficiencies is less likely to happen in the United States than elsewhere. Despite what it may seem like sometimes, the U.S. economy is considered to have one of the easiest and most consistent regulatory climates of any developed country. This is why many economists are concerned when they hear cries for more regulation, and why they became concerned with some of the proposed policy changes that came with the recent economic crisis—they want to preserve the “stable state” the United States offers for capitalist commerce.

21. INTEREST RATES

An interest rate is the price a borrower pays to borrow money. The key word is price—for whatever reason, possibly owing to the negative references to the borrowing and lending of money in the Bible, the concept that interest is a price paid for the use of something, in this case, money, is poorly understood by most. If you think of interest rates as a price, sometimes too high, sometimes a bargain, you’ll learn to make better decisions when evaluating a borrowing opportunity.

From your point of view, interest rates are a price, or cost, of using money. They are also the price, or benefit received, for letting someone else use your money, as in when you deposit money in a bank or buy a bond. Finally, on a national scale, interest rates are also a vital tool used by governments to control money supply and the availability of credit, and thus to exert some control over the economy.

What You Should Know

Interest rates are normally expressed as a percentage of a borrowed balance over the period of one year. Many interest rates are quoted as a nominal, or ongoing, interest rate, with an “annualized percentage rate” quoted in parallel to account for all borrowing costs, including fees, associated with a borrowing transaction, on an annual basis. Federal law requires publication of APRs to allow simple “apples-to-apples” comparisons of the price to borrow money.

The interest rate, or price, for the use of borrowed funds depends on several factors:

Length of loan term. How long will you keep the money you borrow? That will influence the price, because of two things. First is the opportunity foregone by the owner of the money to spend it or invest it in something else. People tend to prefer liquidity—that is, to have their money available to spend. Second is the risk of default or inflation, which increases the longer you hold the money. Under normal circumstances, the longer you hold the money, the more you will pay for it, and if it’s your money, the longer you lend it, the more you can collect.

Inflationary expectations. When inflation is high—that is, money is losing value fast—you’ll be able to pay back with cheaper, more plentiful dollars later. As a result, high inflationary expectations usually lead to higher nominal, or quoted, interest rates, although the real interest rate (interest rate minus inflation rate) may stay the same.

Risk. In any lending situation, there’s always the risk that the borrower will go bankrupt or not be able to pay back for some other reason. As a result, lenders assess this risk, sometimes very methodically, and may charge a risk premium (see #24 Risk Premium), or an interest rate above the going market rate, to account for this risk. A company or government entity with a poor credit rating, likewise, will be forced to pay higher rates.

Taxes. The interest paid by municipalities and certain other public entities is nontaxable, so these entities can pay a lower interest rate and the recipients still come out the same, since they don’t have to pay taxes on the income. As a result, tax-free bond interest rates can be 20 to 40 percent lower than taxable interest rates.

There are literally hundreds of different interest rates in the marketplace for different kinds of loans or securities of different term lengths, risk factors, and tax status. For most people, the following are most important:

BORROWING RATES

Fed funds rate (see #31 Target Interest Rates) as a leading indicator of other rates and general Fed economic policy

Prime rate (see #22 Prime Rate), another barometer of market interest rates

30-year mortgage rate

Credit card interest rates—not because they change but because they can be very costly, as much as 25 percent above “market” interest rates. That’s an expensive price premium.

SAVINGS RATES

Certificate of Deposit (CD) rates, an important form of savings

Money market rates (see #76 Money Market Fund)

Why You Should Care

Interest rates affect all of us directly or indirectly. Directly, they determine how much we pay to borrow money for homes, cars, education, and so forth, and they determine how much income we receive on savings—which has been a big issue for many lately who depend on interest income, especially to fund retirement. Indirectly, interest rates and changes in interest rates can give strong clues to which way the economy is going, and which way policymakers want it to go.

22. PRIME RATE

Not too many years ago, news headlines featured any change in the so-called prime rate. Whenever it changed in one direction or the other, it was considered news. Although it has declined in importance, the prime rate is still used as a benchmark or reference interest rate by banks, economists, and others in the business world.

What You Should Know

The prime rate, or “prime lending rate,” is, in theory, the interest rate banks charged their best, lowest-risk customers. The loans in question were largely unsecured and short term, so the prime rate was a representation of how much the credit was really worth in the marketplace. These days the prime rate is more likely tied to Treasury security rates or to “average cost of funds” figures published by the government; some interest rates are quoted as a percentage above or below the prime rate.

In the United States, the prime rate has typically run 3 percentage points, or 300 basis points for those of you wishing to sound financially sophisticated, above the target federal funds rate set by the Fed.

Why You Should Care

Most people don’t care as much about prime rates as they did ten to twenty years ago, although they are still used as a benchmark for change. Today, the Fed funds rate, Treasury bill and bond rates, and mortgage rates are more broadly accepted measures of interest rates and interest rate direction.

23. YIELD CURVE

Economists and others in the financial community use the yield curve to plot the relationship between yield, or interest rate return, and maturity, or length of time a debt security is held. The most frequently reported yield curve compares the three-month, two-year, five-year, and thirty-year U.S. Treasury debt.

Generally speaking, the longer a debt security is held, the higher the interest rate. That’s because of the greater opportunity costs and the greater risks, including inflation, over the longer time period (see #21 Interest Rates). But depending on economic circumstances and central bank policy, the relationship between yield and maturity can change or even reverse. So economists watch yield curves closely for signs of economic health, and financial professionals watch the curve for signs of preference for different kinds of debt securities, such as mortgage rates or bank lending rates.

What You Should Know

The normal yield curve (Figure 3.2) shows rates gradually rising as maturity lengthens. This curve can be steeper if investors see more risk in longer-term securities, typically in inflationary times or times where other risk factors like corporate defaults come to the forefront. The yield curve typically flattens (Figure 3.3) when the Federal Reserve raises short-term interest rates to slow the economy, and can even go to an “inverted” state (Figure 3.4), where short-term yields exceed long-term yields, if the Fed acts strongly to restrict money supply. Economists see an inverted yield curve as a sign of a looming recession if the economy cools, as the Fed apparently desires.

Figure 3.2 Normal Yield Curve

Figure 3.3 Flat Yield Curve

Figure 3.4 Inverted Yield Curve

You can watch the yield curve by observing short– and long-term Treasury security and other rates in the financial section of a newspaper or websites. The U.S. Treasury publishes yield curve data (not a chart, unfortunately) at www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml.

On July 1, 2013, the following rates were posted on this Treasury webpage:

View a text version of this table

It’s not hard to see that these rates, although ticked up slightly from earlier in the year, are still historically low. It’s also not hard to see that for income-oriented investors, this is a grim story—while if you’re a borrower, this is attractive, although since you’re not the government, you don’t get to borrow at these exact rates. In fact, especially at the “short” (time to maturity) end of the curve, by the time you consider inflation, you’re really paying the government to hold your money for you.

If you’re an active income-dependent investor, you’ll want to watch these numbers carefully, and if you’re a numbers kind of person in general, it’s interesting to watch these figures fluctuate.

Why You Should Care

Aside from the economic signals it sends, the yield curve also helps you figure out the best “deal” for your money as a depositor or borrower. If the yield curve is relatively flat or inverted, it is best to look for shorter-term CDs or other time deposits; likewise, it’s a better time to look for a longer-term, say a thirty-year, mortgage. If the curve is normal and steep, a thirty-year mortgage will cost significantly more, and you’ll do better if you can stretch your payment into a twenty-, fifteen– or ten-year mortgage. As an investor, you should seek longer-term savings deposits or bonds.

24. RISK PREMIUM

In economics and finance, the “risk premium” is the expected additional return on an investment to compensate for the risk of that type of investment. It is the difference between the actual return rate and a “risk-free” return rate often represented by Treasury securities or some other risk-free standard.

In finance, the risk premium can be the expected rate of return above the risk-free interest rate. When measuring risk, a common-sense approach is to compare the risk-free return on T-bills and the very risky return on other investments. The difference between these two returns can be interpreted as a measure of the excess return on the average risky asset. This excess return is known as the risk premium.

What You Should Know

The explanation of risk premiums can get fairly technical, so the best way to describe them is by example. Suppose you’re considering buying a ten-year corporate bond that pays 4 percent. If a ten-year Treasury bond is currently paying 2 percent (see #23 Yield Curve), then you would be receiving a additional 2 percent to cover the risk of the company’s credit quality, or default. Similarly, if you buy a stock expecting a 5 percent or greater return on it, the difference between that return and 2 percent would be your expectation to compensate you for the risk.

Part of the reason the normal yield curve (see #23 Yield Curve) slopes upward as maturity lengthens is to cover the additional risk inherent in longer maturities. That risk can come from default risk, interest rate risk (the risk that interest rates might rise over the holding period), and inflation risk. All three of these types of risk are built into a risk premium. The risk premium also takes into account any collateral pledged on the loan and the “seniority”—that is, the order in which any debt would be paid in a bankruptcy or liquidation.

Why You Should Care

Unless you’re employed in the world of high finance, you probably won’t encounter the term “risk premium” very often in your work, or even in your investing. It’s best to think about it conceptually. When you make an investment, you should ask yourself: “Does the expected return on this investment compensate me for the risk I’m taking?” If it does, the risk premium is in line with reality, and the investment may make sense. If the risk premium is insufficient—that is, the payoff doesn’t compensate you for the risk compared to a risk-free return—look elsewhere.

25. BOND PRICES VERSUS INTEREST RATES

“Bonds were up today. The ten-year Treasury was up 23/32 in active trading.”

You hear it on the news. But what does it mean when bond prices go up? Is that a good thing, like hearing about stock prices going up?

The answer is—it depends. Yes, the above news item is usually good news. It’s obviously good news if you already own bonds—your bonds went up in value. But it’s also good news if you’re planning to borrow money, because it means market interest rates are lower.

What You Should Know

When a bond price goes up, that means market interest rates have moved lower. Why? Because bonds are sold originally with a fixed coupon, or interest payment. A bond issued and sold at a typical $1,000 face value that yields 4 percent will pay exactly $40 per year in interest, period. It may pay that interest once a year, or in two semiannual payments of $20—that doesn’t really matter.

Even though most bonds are issued in $1,000 increments, they’re quoted as if they sell for $100, a figure known as par. If that bond rises 23/32 (of a dollar), that’s the equivalent of saying the bond price rose 71.9 cents to $100.72. Returning to the $1,000 face-value scenario, if you take the $40 in interest and divide it by $1007.20, you’ll get an implied interest rate of 3.97 percent, down from the 4 percent it was originally sold for.

Here’s the “it depends” part of bond prices and interest rates. Normally, the rise in bond prices and the corresponding fall in interest rates are a good thing. But first, that’s only true if you’re a borrower—if you’re a saver, you prefer higher interest rates. Second, the rise in bond prices can often occur as a “flight to quality”—when other assets such as stocks are perceived as more risky, and investors flock to bonds. This may push interest rates down, but only at the expense of other economic pain.

Why You Should Care

So if you hear that bond prices rose, that means interest rates—rates you would receive or rates you would pay, say, on a mortgage or car loan—are going down. Conversely, if bond prices fall, that means that interest rates are going up. Especially if you’re in the market for a mortgage, you want to watch the ups and downs of the bond market closely.

26. GOLD STANDARD

Are your dollars as good as gold? That’s the central question to understanding what a gold standard is and how it works.

What You Should Know

In the gold standard monetary system, paper currency is pegged and convertible into preset, fixed quantities of gold. The supply of money is specifically tied to gold reserves held by central banks (see #16 Money and #17 Money Supply). The gold standard prevailed during the late 1800s and the first half of the twentieth century, but gradually subsided starting in the Great Depression, and was done away with altogether in 1971, after many years where $35 in paper could be exchanged for an ounce of actual gold. This means that central banks, including the Federal Reserve, effectively have no constraints in terms of expanding and contracting the money supply to affect monetary policy (see #56 Monetary Policy).

The gold standard was designed to protect a nation from abuses of monetary policy, and specifically the risk of hyperinflation from an overexpansion in the money supply. Today, we trust governments and central banks not to get carried away with monetary policy. Since no country actively uses the gold standard, those living in fear of hyperinflation buy the metal outright, and have pushed the price of gold up to a recent high of more than $1,900 an ounce, although it has subsided to the $1,200–$1,400 range recently—still high by historical standards.

Many economists following a traditional, pure capitalist, laissez-faire, government-can-do-more-harm-than-good doctrine favor a return to the gold standard (see #59 Austrian School). Doing so would be difficult and painful now, as the rate of currency growth has far outpaced the rate of gold production from mining. A return to the standard would entail a drastic reduction in the value of the dollar and most other currencies, as there wouldn’t be enough gold to go around to back all of the dollars and other paper currencies in circulation.

Why You Should Care

The gold standard debate is theoretical for most of us, but serves as a reminder that money is simply a commodity, and if there is too much of it, its value goes down. Many investment advisers recommend holding at least some gold in your portfolio, as the actual metal or as commodity futures or gold mining stocks, to anchor at least a portion of your wealth to a gold standard. That’s up to you—and there are plenty of downsides—but understanding the gold standard can help you think through such an investment.