All too often I hear illegitimate talk about “the economy” by people who clearly are not educated to the way an “economy” really works. At the office water cooler, small talk with strangers, family and friends discussing the past, present and future states of the economy are all instances where I have heard complete fallacies spoken of as if they were fact. It is my goal to address this lack of education and disseminate a high-level view of economics so that the next time your co-worker starts pontificating about how the housing market and/or the credit crisis will be the ruination of the U.S. economy, you can reply with knowledge and confidence that they have no idea what is going on… but you now do.

Firstly, when you hear people talk about “the economy” they are referring to the macro economics involved. A country’s economy is typically represented by what is known as the Gross Domestic Product (GDP). This represents the total value of all goods and services produced, distributed and consumed in the country. GDP can be broken down into four major components:

• Government spending
• Consuming spending
• Investment (gross domestic capital investments by businesses – international investments do not count)
• Net Import/Export value

So, what does all that mean and how can it help you understand the murky picture of the currently dreaded “economy”? In order to answer that question we will need to expound on each of the GDP components and how they interact.

Government Spending

This one is pretty straight-forward in terms of definition – the total value of government spending, from employees to office supplies to tanks for the army. Where does the government get the money to spend? You. Tax revenues are the major source of money that contributes to government spending; however, in recent years with the U.S. government budget being in a deficit, there are various borrowing instruments (Savings Bonds, Treasury notes, etc) through which the government borrows money to fund programs and other purchases. The U.S. Government has also been “borrowing” money from the Social Security fund, which is another contributing factor to all of the talk about Social Security being under-funded. The government has always borrowed using these instruments, but in recent years has relied on them much more heavily. A common misconception is that a government deficit is necessarily a bad thing. On the global scale, if some governments have surplus it means others will have a deficit. This is because countries like the U.S. lend money to developing nations, in hopes that the interest-bearing loans will at least break even in the long run and will assist developing nations build up their infrastructure at the same time.

Consumer Spending

The total value of goods and services that the people of a country consume. Things like milk, gasoline, televisions, heating oil, and houses fall under this category. These goods and services can either be purchased with cash or borrowed money (credit cards, loans, mortgages, etc.).

Investments

The total value of capital investments made by businesses on property, buildings, equipment, etc. Other expenses for a business fall into the consumer spending category because they are not considered “durable,” or having a life of longer than one year.

Net Import/Export

This is the result of taking the total value of exports and subtracting the total value of imports. The United States has almost always experienced a net import/export deficit, meaning that the total value of imports exceeds the total value of exports. It is commonly referred to as the “trade deficit”.

With this knowledge, let’s apply it to some commonly discussed economic situations:

Housing slump

The housing slump hurts the Consumer Spending portion of GDP. When the rate of housing purchases slows, this has a severely negative impact on the consumer spending component as houses are typically the most expensive thing a family/person will purchase. The strange dichotomy to this situation is that when people aren’t spending on houses they are normally saving more of their money. This results in the banks having a larger pool of funds to lend, but less customers to whom to lend. This ultimately will result in a lowering of interest rates because interest rates are a reflection of the aggregate demand for money. With more money available for lending and less demand, the rates will inevitably lower over time. This will more than likely result in a turnaround in which consumers recognize the lower interest rates and begin to purchase homes again because the cost of borrowing is down. Over time, the “housing slump” will correct itself via falling mortgage rates and property values.

Credit crisis

The credit crisis is a reflection of consumers who purchased houses they could not afford at the time, but with the “creative” mortgages available were able to meet initial payments. When the interest rates on these mortgages began to rise over time, as they were intended to, some consumers’ ability to repay the higher cost monthly payments fell far short of their personal forecasts. This resulted in an unprecedented number of people deciding to take the one-time black mark on their credit reports and foreclose on their mortgages, thus transferring the property back to the bank that held the mortgage. Economically speaking, the initial capital outlay was what impacted GDP and the foreclosure has little to do with current GDP performance. In fact, these individuals may actually have more cash in the short term to put into the Consumer Spending component of GDP. So, it is technically possible that the “credit crisis” may actually bolster GDP because people have more cash in their pockets to spend. The danger is really to the banks in this instance, now flush with property that they are getting a negative return on because lower housing prices (see above) are resulting in losses on the property, which the banks now have to absorb. This is a problem because when banks are experiencing profitability issues, they raise interest rates on loans and lower interest rates on savings instruments. This will directly conflict with the “natural” solution to the housing slump as described above, because a key ingredient to solving the housing slump is lower, not higher, mortgage rates. This is why the situation involving both of these issues is so concerning: the solution to one problem is in direct conflict with the solution to the other.

Inflation

Like most economic issues, inflation is a result of many factors. One of the most [ad#babeled-ad-medium-square]prominent is the production of money. The Federal Reserve decides to print a certain amount of new money each year. If in any given year this amount is more than the annual increase in GDP, then there is a subsequent increase in inflation because more money is in circulation relative to the total picture (GDP) than the year before. Inflation is also at the mercy of supply and demand for money. This is how interest rates come into the inflation discussion.

Unemployment rate

The unemployment rate of a country is typically a lagging indicator of the economy. What this means is that changes in the unemployment rate usually occur after the economy has been impacted one way or the other. This makes intuitive sense because if the overall picture of the economy is good, it means that businesses are profitable and are looking to increase their workforce in order to meet consumer demand. This happens after the economy is already doing well, however, because businesses typically hire reactively, not pro-actively. An increasing unemployment rate occurs after the economy takes a downturn because businesses are looking to cut costs as a result of decreased consumer spending. This will then increase profitability and theoretically maintain a status quo for the Investment component of GDP.

Falling value of the Dollar

The value of the U.S. Dollar relative to foreign currencies impacts the net import/export component of GDP. As the U.S. almost always operates at a trade deficit with the rest of the world in aggregate, the falling dollar is of utmost concern. A dollar now purchases less product than it used to, thus increasing the total VALUE of imports without increasing the total QUANTITY of imports. However, foreign countries can now purchase American products for less of their native currency and are more likely to import products from the U.S. This will help to counter the increased cost of imports into the U.S. In the end, the declining value of the dollar will have a more negative impact to the net import/export figure since the imports are so much larger than the exports.

There certainly are many more issues and facets to this discussion. This was not meant to be an economics class, but an overview of some terminology and some current events issues. Hopefully this will arm you to be the star of your next office water cooler chat on the state of the economy.

Image Credit

Federal Reserve Building in NY