At Proof Through the Night we believe that some understanding of basic economics is essential to making informed political decisions. Just as you need some sense of your personal income and expenses to intelligently make decisions about your goals and future, you need some sense of the nation’s economy to make intelligent political decisions about issues that affect you and those you care about.
Many people don’t like to think about economics and money, but remember, learning this information increases your political power! Not only does it increase your political power, but it can also inform some of your major life decisions, such as whether to buy a home or seek a new job — both decisions may be affected by the state of the economy.
Economics in this course is divided into two chapters. The chapter you’re in is basic economics. It covers basic economic realities including why certain problems keep appearing — problems such as poverty, inflation, concentration of wealth, corruption, business failure and market failures.
The next chapter covers special topics such as the buying power of large sums of money, the federal deficit, and international trade/globalization.
In the critical thinking course there will be a chapter on thinking economically and policy analysis. That’s one place where you’ll begin to use the basic knowledge that you learn here.
People have needs and people want things. They need things like food and shelter and they want all kinds of goods and services, from cars to clothing to enjoyable music.
That’s the start of the economy: You can’t produce everything you want or need, so you spend money. To get the money you usually go to work.
The simplest picture of the economy consists in groups of people that organize as businesses to produce goods and services. Before they can produce, they need three things: land or some raw materials; capital which is the factories, equipment and know-how to transform the raw materials into products; and people to do the work of production.
One of the prime roles of government is to produce public goods. Public goods are things like roads, public education, police departments for safety, and armies for defense. Specifically, roads and other forms of infrastructure make it easier for businesses to operate. Public education means that businesses need far less time to train workers. Armies protect the nation from threats that would interfere with people producing the goods and services that others want or need.
People work in order to make money, but also because they often feel good when they produce useful goods and services. Businesses operate to produce goods, but also to make a profit. In general, the price of a good or service must always be equal to or greater than the cost of production — otherwise the business goes into debt or out of business. Prices for the same or similar goods must also be competitive, or again the business that charges too much more than others will go out of business.
Businesses that produce the same goods in roughly the same geographic areas are in competition with each other. The more competition, the harder it is to make a profit. Business want to avoid highly competitive situations, so they use a variety of strategies to try to limit competition or gain advantages over their competition.
Perhaps there are three basic truths in economics. 1) Since there’s not an unlimited supply of the things we need and want (scarcity) we need to make trade-offs. 2) People respond to incentives. For example, if the prices go down on a product, people will usually buy more of it. 3) Markets and trade tend to make most people better off. They can produce win-win situations where both the buyer and seller are better off. Both are wealthier, and so in a sense markets create new wealth. (Source: Mike Hammock / YouTube.)
The very poor and the very rich exist for three basic reasons. First, people have different amounts of marketable talent and skills. For instance, if you are born very bright, or with great music or artistic talent, if gives you economic advantages. Second, some people are born into rich countries and families, and others start out life in countries with very few resources and less infrastructure. Third, there is the principle of “the rich get richer.” This means that people who start life out with more resources and talents, get more money than they need, and the extra money they invest. These investments usually earn them even more money, and they re-invest.
Another role of government is to try to “level the economic playing field” and also keep people from being economically trapped. Certain businesses that get an early advantage will tend to become monopolies. Being a ‘monopoly’ means they are the sole or main provider of a product. For instance, Alexander Graham Bell invented the telephone and got a patent on his invention. This prevented others from benefiting from all the development work and time he took to invent the phone. But it allowed the Bell Telephone company, later called ATT, to start with a huge competitive advantage. On top of that, the semi-monopoly normally granted to utilities allowed ATT to charge high prices for phone calls, since no one else could compete. The US government eventually stepped in to break up the ATT monopoly to re-create competition. As a result, the price of phone calls went down, but phone companies were still able to profit.
As mentioned, businesses in a highly competitive market make very little profit. So businesses are always seeking some competitive advantage. Legitimate ways to gain advantage are to create better products, or to come up with more efficient ways to produce products. Illegitimate ways include paying kickbacks to government workers and others to get contracts. They also include paying politicians or funding political campaigns to influence the politicians to create laws that favor the business or increase its profits. Laws that decrease environmental standards or worker benefits are examples of laws that can increase a company’s profits or their competitive advantage over companies in other countries with higher standards. These same laws harm workers, consumers or the general public.
Another function of government, together with banks, is to regulate the money supply. Businesses normally need loans in order to buy the capital equipment to expand their business. If the available money in circulation is small, there is a relatively high demand. When there is high demand, the cost of the loan (the interest on the loan) is high. High interest rates discourage expansion and investment. If there is too little expansion in a certain country, the competitive advantage goes to businesses in other countries. They can then employ more people in the other country. Meanwhile, the people in the country with higher interest rates suffers. Less people are employed.
A secondary impact is that less employment means less taxes. Less taxes mean that the government can do less to maintain or build the quality of life in that country. If there is more unhappiness in a democratic country, the people often vote out the people in power. So, both because they don’t want to lose power, and because they want to be remembered as successful leaders, politicians will try to improve the economic situation.
Before explaining the tools that government leaders have to affect the economy, we need to say something about business cycles. For at least three hundred years there have been business cycles. These are alternating times of high employment with economic growth followed by times of economic stagnation and lower employment. The reasons for the boom and bust cycle are not fully understood even today. In other words, there is no one widely held theory for these cycles. However, the impact of many individual factors are understood, such as the impact of investment, the size of the money supply, consumer demand, and also automation, which lowers the employment rate.
In general, the goal of governments and businesses is to foster long-term growth.The basic strategy is to invest in the four inputs to long-term growth: human resources, natural resources, capital and technology. For instance, investments that create a healthy, well-educated workforce will make it more likely that growth occurs. But again, there is the problem of uneven growth, boom and bust cycles. So to try to keep things in balance, government must first have good measurements of the economic situation. In the news you will hear of economic indicators such as:
The unemployment rate. This number is released monthly. Often, however, the real unemployment rate is higher, because this is the number of people who are actively looking for a job. Others have given up.
Consumer price index. This measures the cost of goods that most people commonly buy. If the price index goes up 5% in a year, that means the inflation rate is 5% that year.
GDP, which means “gross domestic product” which is the productivity of people in a certain country. In the US the GDP number comes out every three months.
“Real GDP” is the productivity adjusted for inflation.
Index of Leading Economic Indicators are a set of measures that usually change in advance of a recession or period of growth. For instance, if the index of indicators drops, there will usually be a recession three months later. In the same way, if the composite goes up significantly, it usually indicates the end of a recession in three months.
Consumer confidence index. This is a scientific survey of people questions about their confidence in the economy. It is one of the Leading Economic Indicators (Since consumers are 70% of who spends in an economy, their confidence is an important indicator of spending in the near future.) Trends in the following three stock market averages in the past have been seen as indicators of the economy’s strength, but more recently they are not as accurate an indicator because most corporations can be profitable even in poor economic times. (Source: New York Times, 12/15/12)
Dow Jones Industrial Average (sometimes called “the Dow.”) An average of 30 key stocks whose values rise or fall. All 30 were incorporated in the US. Some are financial institutions like Goldman Sachs, J.P Morgan, Visa and American Express.
S & P 500. Like the “Dow, but an average of 500 stocks that include “foreign” corporations.
NASDAQ or NASDAQ-100. 100 companies, some foreign, but with no financial institutions.
How the government influences the economy
In order to try to stimulate growth or slow inflation, governments have two kinds of tools: Fiscal policy and monetary policy. Fiscal policy has to do with the government’s own budget. If the federal government lowers taxes, then people have more money they keep and more they can spend. This extra money usually stimulates the economy. If the government spends more money (often going into debt) it also stimulates the economy.
Monetary policy has to do with planned changes in the money supply and interest rates. There are three tools of monetary policy: open market transactions, discount rate changes and changing the reserve requirements. These may sound technical but they all are easy to understand.
Open market transactions are the sale or purchase of government securities by the Fed. The Fed, or Federal Reserve is actually not part of the U.S. government, it is a group of 12 regional banks. These are the banks that print American dollars. They hold government securities, bonds, that back the paper money. The Fed has regular meetings, and using some of the economic indicators listed above, they decide whether to try to stimulate or restrain the economy. If restraint is called for, they buy securities which lowers the reserve cash they have. Thus they have less to loan, and so interest rates go up. Businesses borrow less at high interest rates.
Discount rate changes have a more direct effect on commercial and consumer interest rates. The discount rate is the rate it changes member banks. If it drops, the banks pass on the drop to consumers. That stimulates the economy. Another rate is the federal funds rate which is the rate at which banks borrow from each other. The Fed can indirectly affect this rater by buying and selling securities.
Reserve requirements means changing the ratio of cash which must be held to money loaned out. If a bank loans out one million dollars in a day, it might only need to have 10% of that in cash on hand. That 10% would then be the reserve ratio. (Thus, banks loan out far more money than they really have on hand! Like airlines that overbook, they count on the odds that people won’t draw out their cash at the same time.)
By the way, a government security or bond is a promise to repay money with interest. Essentially, it’s an IOU. For example if you by a T note, or treasury note, you will get more money when the bond “matures,” in other words, reaches the contracted time for repayment.