Mon 21 Jan 2008
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), and the 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 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.
Federal Reserve Bank building in New York
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.
Picture: http://www.nyc-architecture.com/LM/LM056.htm
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13 Responses to “ The Economy for Dummies: What does it all really mean? ”
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January 21st, 2008 at 4:25 pm
International Markets hit a big stall today in response to US Economic woe.
“Europe’s Dow Jones Stoxx 600 Index fell the most since the Sept. 11 terrorist attacks and sank into a bear market, as Allianz SE and BNP Paribas SA slid. Hong Kong’s Hang Seng Index had its biggest drop in six years after BNP Paribas said Bank of China Ltd. may write down overseas securities by $4.8 billion because of losses from U.S. subprime mortgages. Citigroup Inc. retreated in Frankfurt.”
You can read the rest of the article at Bloomberg.com
January 21st, 2008 at 4:28 pm
Indeed. As noted by the trade deficit, the U.S. is a huge consumer of goods from overseas. This means the U.S. is very important to other countries’ economies as they rely on U.S. consumer spending.
January 21st, 2008 at 9:04 pm
I have heard rumors. I need a good answer to this: Do you think that our country is heading into a recession? Will it be as bad as the Great Depression, will it be more global as indicated by the trade deficit, and how well will our economy be able to rebound, if at all?
January 22nd, 2008 at 6:22 pm
I like your timing - I was planning on buying a book on Economics 101 since I know I’m completely clueless about “The Economy”. This was an informative introduction to the macro side of things.
Also, in regards to the falling dollar, the Federal Reserve announced an emergency lowering of interest rates today. Will it help? Or is it too late?
You can read the article at Reuters.com
January 22nd, 2008 at 7:23 pm
@ Rineberg - I can’t answer that question. No one can, anything you hear will be a forecast of varying degrees of reliability, depending upon your source.
That said, we are in danger of heading into a recession. Recession is defined as two or more quarters (3 month period) of decreasing GDP. We have seen GDP rates still on the positive side of zero, but the rate has been dropping in recent quarters, with growth being slower than economists predicted.
Great Depression-esque? I highly doubt it, but nothing is impossible.
@ Andrew - The Federal Reserve dropping key rates will unlikely impact the value of the dollar at all. What it will do is decrease the cost for banks borrowing funds from the Federal Reserve bank system, thus slowly lowering interest rates of all types for various reasons. This will assist banks become more profitable again, while lowering interest on loans/mortgages to consumers at the same time. This move was made to address the credit crisis and the housing slump, not the value of the dollar.
January 24th, 2008 at 3:11 pm
Everyone hear about this “Economic stimulus package” being presented by the President? Well, if you look at it using the knowledge contained in this article, then you will quickly come to the same realization that I have: this does nothing to improve GDP because the only thing that is happening is the government is shifting money from the Government Spending category to the Consumer Spending category. There is no net gain to GDP, and depending on what people do with their meager $600 per person (plus $300 per child) refund, there may actually be a net decline in GDP if people choose to save the money rather than blowing it all at Best Buy and Target.
January 24th, 2008 at 3:49 pm
How about the fact that the fruits of my economic stimulus will be spent in Europe?
January 24th, 2008 at 4:16 pm
Ironic, no doubt. I mis-spoke somewhat with my comment above because I realized that while the government is intending to curb spending in order to help finance this “stimulus”, the cuts will be less than the total value of the stimulus, thus the impact is really more of a growing deficit rather than a complete shifting of monies from one category to another.
January 28th, 2008 at 8:34 am
I was researching the same thing when I saw this.. I can not agree more - but I am still going to look for a better source
January 29th, 2008 at 8:13 pm
Excellent, if you happen to stop back I would be very interested to hear what you have found. This topic is of much interest to me, and good sources of information are hard to come by, I find.
October 8th, 2008 at 5:16 am
a dummy says thanks! H.