Usually when an Economics book claims to condense core ideas into a short frame, it is best for the reader to be on The Little Review of Economics
Usually when an Economics book claims to condense core ideas into a short frame, it is best for the reader to be on the lookout for ideological biases. It is hard to boil down the opposing ideas that make up Economics into any simple framework without committing many sins of omission.
As all such books do, Ip too starts with the set formula of Economics text books: first give a brief on how economics is perceived as such a hard and complex discipline and then assure the reader that in this book it is presented in a simple and concise manner. What is left out in such introduction is the fact that the book hardly ever even attempts to address the whole field.
Contrary to most such books, Ip manages to steer clear of obvious bias and also manages to keep the explanations simple enough for the lay reader (though he uses sections called "into the weeds" to explain more complex concepts) In all, this is a cute little book to have and it can serve as a useful introduction. Ip never goes beyond the most basic of concepts and never ventures into the really controversial areas - that is how he keeps it simple and bias-free. This reduces the usefulness somewhat, but on the other other hand, it makes it a book that can be recommended to a novice student without fear of early distortion. Which was my purpose in reading this one.
Why do some countries grow and some stagnate? In a nutshell, growth rests on two building blocks: population and productivity.
1. Population determines how many workers a country will have.
2. Productivity, or output per worker, determines how much each worker earns.
Thus we arrive at the following recipe:
a. Take a Growing Population
b. Add Capital
c. Season well with Ideas.
d. Stir with a good dose of Human Capital, Rule of Law & Well-functioning Markets
e. Serve and monitor step d for deviations.
In Short:
• Long-term economic growth depends on population and productivity. A growing population is the source of future workers, and the more productive those workers are, the richer they become. It takes investment in both capital and ideas to raise productivity.
• Ideas enable us to recombine the workers and the capital we already have in new ways to produce brand-new products or old products at a lower price. Competition forces countries and companies to copy each other’s ideas and constantly come up with new ones.
• Both investment and ideas must be nurtured. Honest government and trustworthy laws encourage investors and innovators to take risks in hopes of reaping the rewards. Investment in education enables workers to take advantage of the latest ideas. And free markets ensure that dying, unproductive industries are culled so that growing industries can attract capital and workers.
Every business expansion eventually dies. Only the cause of death changes. Economists often miss fatal imbalances because they’re looking in the wrong place. Having vaccinated everyone against whatever killed the last business cycle, they fail to spot the virus that infects the current one. Depressions occur when the economy’s normal recuperative mechanism fails to engage.
• Ultimately, long-run growth drives our standard of living. In the short run, the economy goes through regular cycles of expansion and recession. These cycles are driven by how much consumers and businesses spend, which in turn depends a lot on their view of the future.
• Bullish expectations boost investment, stock prices, and lending, all of which feed back to the economy. Eventually, though, expectations get ahead of fundamentals, creating imbalances. These imbalances come undone, usually with a nudge from the Federal Reserve, producing recessions.
• Recessions create pent-up demand. Lower interest rates eventually release that demand, bringing the recession to a close. Sometimes, though, this natural restorative process fails, because a broken financial system dams the flow of credit. Then, a recession may become a depression.
3. Tracking and Forecasting the Business Cycle (from Takeoff to Landing)
The Four Engines of the Economy have to be running smoothly for it to operate well. These are the ones we should monitor (in the order given) to be able to predict (with reasonable confidence) where the Flight is headed:
2) Business investment in buildings, equipment, and inventories: 8% to 13% of GDP
3) Government spending: 18% to 20% of GDP
4) Exports: 8% to 12% of GDP
Consumer spending is the economy’s ballast: though large, it doesn’t fluctuate much from quarter to quarter, except for big-ticket purchases like houses and cars.
Housing though a form of consumer spending, behaves differently from the rest of this category - it is a highly volatile component, one of the most volatile things in the economy.
• Movements in GDP are dominated by such "most volatile" categories of spending: housing, business inventories, and big-ticket consumer purchases, like cars.
• Forecasting the business cycle is risky business; you have to carefully monitor a continuous blizzard of data which, though faithfully gathered, may be out of date and inaccurate. Stock prices, the yield curve, and commodity prices are all useful leading indicators but send a lot of error signals.
4. Employment, Unemployment, and Wages
• In the short run, the number of jobs rises and falls with the business cycle. In the long run, though, the growth in jobs usually tracks almost perfectly the growth in the number of people who want jobs.
• The unemployment rate is the single best signpost of the economy’s health. When the economy reaches full strength, the unemployment reaches its so-called natural rate.
• Pay usually tracks productivity, which is why, over the years, workers have gotten richer. In recent decades, however, the best-paid workers have seen their salaries grow much more rapidly than the rest of the work force has, because of the premium on skills, weaker unions, and superstar salaries, whether for lawyers or for athletes.
5. Inflation and Deflation
There are two competing schools of thought on the causes inflation:
a) Monetarism - blames inflation on too much money chasing too few goods. This makes great sense in theory but is less obvious in real life.
This is because the central bank doesn’t control the entire money supply, only a narrow portion of it: specifically, the notes, coins, and reserves it supplies to commercial banks.
For money to cause inflation, it must be lent and spent. Banks lend more only when they have healthy balance sheets and a lot of eager, creditworthy customers. Consumers spend when they feel confident about their jobs and salaries - both these things are not controlled by the Central Bank's actions directly.
Monetarists claim that growth in the money supply leads to more spending and more inflation. Actually, it’s the other way around. Every dollar consumers borrow or spend returns to the banking system and shows up in someone else’s checking or savings deposit or money market mutual fund, which are all part of the broader money supply (which has labels like M1, M2, and M3).
For this reason, the Fed doesn’t target the money supply. It uses its control of reserves only to ensure banks have enough cash to keep their ATMs full, and to control short-term interest rates. Therefore, its influence over the broad money supply is indirect. If it raises interest rates, it will dampen spending and, eventually, the money supply. If, however, the economy is truly moribund, because no one wants to lend or borrow, the Fed can drive interest rates to zero and print gobs of money without causing broader measures of money and credit to grow.
b) So save some trouble and don’t preoccupy yourself with the money supply. For a more realistic picture of inflation— look at the neo-Keynesian picture.
• The money supply is a lousy guide to where inflation is going. Better, instead, to monitor how far the economy is operating from its capacity. For example, if unemployment is 5 percent, it doesn’t have much spare capacity left. Wages are the best evidence of an economy running out of capacity. If wages aren’t rising, a wage-price spiral can’t happen.
• Inflation is more likely to rise if people expect it to, because they’ll adjust their wage and price behavior accordingly. Stable inflation expectations are a bulwark against both inflation and deflation.
6. Globalization
• Falling trade barriers, rising affluence, and the plunging cost of selling things across borders have fueled globalization. Able to buy from and sell to the entire world, even small countries can achieve exceptional levels of wealth.
• Trade makes the United States a whole richer. But the benefits are not shared equally. Especially as services trade grows, the biggest gainers will be the highest skilled workers while those with the least skills will see their wages eroded.
• Free trade is not politically popular and every country routinely indulges its protectionist impulses. Yet free trade survives because countries have also agreed to subject their actions to the rules of the World Trade Organization which keeps trade spats from becoming trade wars.
7. The International Market
• Global capital markets let investors diversify their portfolios and borrowers choose from different sources of capital. There’s a downside, though: Investors’ savings may be battered by events in far off countries, while companies and countries can abruptly have their access to capital cut off.
• Currencies over time reflect their purchasing power and thus countries’ inflation. But in the short run, economic growth, interest rates, and current and capital account balances drive currencies, sometimes violently.
• The United States borrows cheaply abroad in great part because foreign central banks like to hold dollars: they’re safe, easy to convert to other currencies, and backed by a strong, stable country.
8. Controlling the Economy (or die trying!)
• Governments don’t control the economy but they sure try. A government’s economic agenda is dictated by ideology, but how it is implemented depends on the circle of economic advisers in the various high profile Economic bodies.
• The governement also exercises a lot of influence through his appointments to dozens of federal regulatory agencies. The bank regulators, for example, influence who gets credit and under what terms while the Justice Department and the Trade dept set the ground rules for business conduct and competition.
9. The Central Bank/Reserve
• The Fed stands alone in its economic sway and its independence. It can print and destroy money at will to protect the financial system from panics and to manage the business cycle.
• The Fed is a compromise between political accountability and private independence. Its politically appointed governors and privately appointed reserve bank presidents make up the Federal Open Market Committee, which sets monetary policy at meetings eight times a year.
10. Monetary Policy
• When setting interest rates, the Fed weighs how far the economy is from its potential, and how far inflation is likely to be from 2 percent. This is harder than it sounds because the economy responds unpredictably and with lags.
• At meetings, Fed officials listen and debate the best path for monetary policy. A few dissent but the chairman always carries the day. The Fed gives out so much information that the result is seldom a surprise but it still moves markets.
• The Fed carries out monetary policy by using open market operations to move the Federal Funds rate, charged on loans between banks, up or down.
• When the Funds rate fell to zero in 2008 the Fed turned to quantitative easing: buying up bonds to push down long-term interest rates. Quantitative easing has unpredictable political and economic consequences.
11. Lender of Last Resort & Crisis Manager
• The Federal Reserve has made its name managing the economy through monetary policy, but its parents had a different career in mind: to act as lender of last resort when banks ran out of cash. The Fed is uniquely suited to the job because it can simply create whatever money it needs to lend, primarily through loans from its discount window, and withdraw the money from existence when the loans are repaid.
• During the financial crisis the Fed dusted off a loophole to lend not just to banks but to a wide assortment of companies. In so doing it may have saved the country from another Depression, but it also awakened politicians to its formidable power.
12. Fiscal Policy
• The federal government is a gigantic player in the economy and it will get bigger in coming years as government services expand, the population ages, and interest on the national debt mounts.
• Federal spending comes in three varieties:
1. Interest on the debt.
2. Discretionary spending.
3. Mandatory spending.
• Tax revenue comes mainly from personal and corporate income and payroll taxes. Compared to other countries, the United States relies relatively little on consumption taxes such as on gasoline or a value-added tax.
• Every year the president proposes a budget; Congress accepts some of it but ignores a lot as it passes the appropriations, tax, and mandatory program laws.
• Unlike the federal government, states must balance their budgets each year, which makes for profligacy in good times and wrenching austerity in bad times.
13. The Debt in the Machine
• Chronic deficits compete with private borrowers for limited savings driving up interest rates, retarding investment, and impairing future economic growth. Interest on the national debt starves other government programs.
• Budget deficits can be good. During recessions, tax revenues fall and spending on the poor and unemployed rises, softening the sting. There’s less competition with private borrowing.
• Governments sometimes use fiscal stimulus—that is, a deliberate increase in the deficit—to boost a weak economy. This is usually unnecessary, unless the Fed is unable to do the job because it has already cut interest rates to zero.
• A breaking point can come when debt is so high that investors suspect governments will try to renege either by defaulting, or through inflation.
• The United States’ long history of fiscal probity, favorable long-term growth outlook and control of the world’s reserve currency, suggest it has a long way to go before it faces a crisis, but the risk can’t be rule out.
14. The Financial Markets
- Stocks are simple and glamorous. Credit is complicated and dull. Yet it matters more to the economy.
- Mortgage-backed securities are a great idea that Wall Street, as is its habit, took to excess.
Years ago you would put your money in a bank and the bank would grant a mortgage to your neighbor. Now, you: • Put your money in a pension fund • Which is a partner in a hedge fund • Which buys a collateralized debt obligation • Which holds a mortgage-backed security • That a bank put together • Out of mortgages it acquired from a mortgage broker • Who made the original loan to your neighbor
Did you get all that?
Anyway,
• You don’t have to hug your banker, but what he does is essential to economic growth. Banks and capital markets match savers with those who need capital.
• Over the years, banks have been joined by shadow banks that, like banks, made loans but don’t take deposits and aren’t as tightly regulated. All these institutions need capital to protect against losses and liquidity to repay lenders. Too much of either, and profits suffer. Too little, and the institution could fail.
• Equities get all the attention in the capital markets but the economy relies more on a healthy market for debt securities, such as money market paper, bonds, and asset-backed securities.
15. The Multiple, Recurring Causes of Financial Crises
- Almost by definition, crises are unexpected because they involve collective errors of judgment.
Condition 1: Afloat on a Bubble
(But, not all bubbles lead to crises. To produce a crisis requires leverage.)
Condition 2: Leverage, the Prime Suspect
Condition 3: Mismatches, the First Coconspirator
(Rising dependence on short-term borrowing is often a telltale sign of trouble -- Mismatch = borrowing short-term to make long-term investments.)
Condition 4: Contagion
Condition 5: Elections
(Crises often come in election years. They are often a result of economic stresses that can only be fixed with painful remedies that politicians running for election don’t want to administer.)
So,
• Every crisis is different but they share certain traits. An asset price that deviates from historical fundamentals may signal a bubble, but not when or how the bubble will burst.
• Debt is a prime suspect in every crisis. Currency and interest rate mismatches, reliance on short-term debt, and moral hazard are all coconspirators.
• Crises are spread through contagion: Investors burned on one company or country flee others that look like it. A failing bank pulls down others with whom it trades or has other relationships. Because of contagion, companies or countries that were merely illiquid become insolvent and collapse.
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