Known as the Father of Economics, Scotland’s Adam Smith was the world’s first free-market capitalist. Smith’s 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations, is recognised as the bible of classical economics. Smith argued that a nation’s wealth should be judged not by its store of gold and silver – the prevailing ‘mercantilist’ view at the time – but by the total of its production and commerce, today referred to as gross domestic product (GDP). He identified the price mechanism as an ‘invisible hand’ co-ordinating the actions of disparate economic agents, and highlighted the importance of the division of labour, supply and demand, technical progress and capital investment as the main engines of economic growth.
Their reputation may have been tarnished in recent years, but in their simplest guise banks allocate capital: savers’ deposits are loaned to those willing and able to borrow in order to invest. And like any good plumbing system, when functioning properly they operate in the background, assisting transactions and financial deals. The problem comes in times of stress, as it did in 2007/08, when question marks over their health jeopardise the entire financial system. Notions of ‘Too Big to Fail’, and the associated moral hazard have plagued them ever since. Far tighter regulatory oversight and capital buffers are now in place, with the result that we are living in different financial times.
Not your typical bank. Part guardian, part regulator, part bank, central banks are responsible for stable prices and the smooth running of an economy. This is done by using monetary policy – setting interest rates or engaging in open market operations to control the money supply – to achieve specific economic goals or targets, such as price stability or maximum employment. Administratively, central banks issue currency, provide banking services to the government, and (more recently) oversee commercial banks and regulate the financial system. They also act as the ‘lender of last resort’, meaning they can provide emerging loans to commercial banks in times of severe stress.
It’s often said that demographics is destiny. English scholar Thomas Malthus once predicted that population growth would result in mass starvation. But many of today’s demographic concerns are about too few people of working age relative to the very young and the very old, rather than too many people. Japan has long been at the forefront of concerns about a rising ‘dependency ratio’, as a shrinking workforce has to fund a growing number of retirees. In the UK and the European Union, for all the controversy it has caused, inward migration of primarily working-age people may offer a way for countries to avoid Japan-style demographic timebombs.
A position of stability in an economy, where the forces of supply and demand are in balance. Traditionally, economies have been viewed as self-correcting, so that if they were pushed away from equilibrium, forces exist that would move them back towards equilibrium. More recently, however, it has become clear that economies can remain in disequilibrium for long periods of time. The period before the financial crisis, when substantial imbalances between importers and exports, or between debtors and creditors, went uncorrected for many years, now looks like an extended disequilibrium. Equilibriums are not necessarily good things: today, the global economy appears to be mired in a suboptimal equilibrium of low growth and low inflation.
The use of government spending and taxation to influence the economy. In many advanced economies, fiscal policy has tended towards a ‘tightening’ bias as part of efforts to reduce budget deficits. These deficits had increased sharply following government rescues of the banking sector.
However, there are growing calls for governments to ‘loosen’ fiscal policy to help promote economic growth. With monetary policy looking increasingly stretched, there is an argument that governments should cut taxes or raise spending – or a combination of both – to boost aggregate demand.
The Gini coefficient measures inequality. It compares the distribution of income in a society with a hypothetical alternative in which everyone earns exactly the same amount. A Gini coefficient of zero represents absolute equality, while a coefficient of one represents absolute inequality. According to some analysts, societies that have a Gini coefficient of more than 0.40 are at increased risk of social unrest. The UK’s Gini score is 0.32, while in the US the score is higher at 0.41. In both countries, inequality has become a highly politicised issue.
Born in 1899, Friedrich Hayek won the Nobel Prize in Economics in 1974 for his work on business cycles. Like Adam Smith, Hayek recognised that the price mechanism helps co-ordinate the action of firms and workers – but he also noticed that this co-ordination can break down, leading to periods when large numbers of firms go out of business and workers become unemployed. Hayek identified the cause of the business cycle as being central bank policy, which has the potential to result in excessive credit creation by commercial banks, in turn leading to firms misallocating capital to unproductive investments that eventually fail.
While free market economies can periodically do a bad job of co-ordinating actions and allocating capital, Hayek thought that central planners did an even worse job. Lacking the distributed information processing of a market economy, central planners were even more likely to plough money into unproductive investments.
Inflation is the rate at which prices rise. As prices increase, the purchasing power of a given quantity of money decreases – causing a multitude of issues, both positive and negative. On the positive side, higher inflation reduces the real burden of repaying a fixed quantity of nominal debt – a process known as ‘inflating away’ debt. On the negative side, inflation increases ‘shoe leather’ costs – the inconvenience of holding small amounts of cash for fear that it will lose its value and making numerous trips to the bank. Furthermore, if the inflation rate becomes difficult to predict, spending and investment decisions can be delayed or put off completely due to uncertainty.
The opposite of inflation is deflation. Falling prices bring their own problems. Firms and consumers will tend to delay spending if they think their money will buy more goods and services in the future, reducing economic activity and generating further deflationary pressure.
Many central banks target an inflation rate of 2% per annum. This is judged low enough to prevent considerations about inflation entering into everyday economic and financial decisions, but high enough to allow the central bank to cut interest rates during a downturn and make periods of damaging deflation rare. Recently, there has been an active debate about raising inflation targets to give central banks more room to cut interest rates in future downturns.
Known for his depiction in the book and film ‘A Beautiful Mind’, John Nash was awared the Nobel Prize in Economics in 1994 for his work on game theory. Game theory describes the interaction of agents in strategic settings – or ‘games’. Auctions, takeovers, the production plans of firms, and the functioning of the macroeconomy as a whole can all be seen through the lens of game theory.
John Nash is known in particular for the Nash Equilibrium – an equilibrium concept in non-cooperative games where no player, taking the other players’ strategies as given, has an incentive to change his strategy. The solution to the Prisoner’s Dilemma, in which both players confess to a crime and receive harsh sentences when they could have stayed quiet and received lighter ones, is an example of a Nash Equilibrium.
Born in Cambridge in 1883, John Maynard Keynes is best known for his General Theory of Employment, Interest and Money, published in 1936 in the depths of the Great Depression. Keynes’ argument was that governments can boost economic activity by spending more. The boost to aggregate demand would in turn encourage private consumption and investment, and could help economies recover from recession. So called ‘demand management’ dominated economic policy-making until the 1970s, when the combination of high unemployment and high inflation revealed its limitations. Keynes’ ideas have been significantly expanded and added to since then, and have come to the fore again in recent years as policy-makers look for ways out of the current low growth equilibrium.
Although Keynes is best known today for his recommendations on the conduct of fiscal policy, he also wrote about the failure of prices, especially wages, to adjust to clear markets (‘sticky wages’); about how uncertainty affects economic outcomes; and – often forgotten today – he was an advocate of free markets once fiscal policy had helped achieve full employment. Keynes was a celebrity in his own time, representing the British government at the Versailles peace conference after World War One, and playing a prominent role in the Bretton Woods Agreement that laid the foundations of the international economic system after World War Two.
Mark Twain was right: it’s virtually impossible to create more land. Economists treat land as a key factor of production, along with capital and labour. Given its fixed supply, the price of land can rise considerably if it contains something of economic value, such as deposits of a natural resource, or if its location is considered particularly desirable.
The money supply is the total amount of money in circulation in an economy. The ‘monetary base’, or M0, is made up of the physical supply of notes and coins, M1 adds in other monetary equivalents that are quickly convertible into cash, M2 adds in short-term deposits held electronically at banks, while M3 adds in longer-term deposits to which savers may not have immediate access.
The quantity theory of money, which relates the money supply to the level of prices, can be traced back half a millennium to the time of Rennaisance mathmetician and astronomer Nicolas Copernicus. He noted that prices tended to increase when a nation imported increased amounts of gold and silver used to make coins. This theory has been debated and expanded over the years, by such luminaries as Kenyes, Marx and Friedman. Essentially the theory states that a rise in the supply of money will lead to a general rise in prices. However, it has been called into question recently, as several bouts of quantitative easing across the world have massively expanded the money supply without resulting in any meaningful increase in prices. As with many economic theories, however, the quantity thoery of money relies on ceteris parabis (all other factors being equal). Whether other factors, such as extreme falls in commodities prices, are exerting a more powerful effect than the rise in the money supply, remains to be seen.
In short, everything that is produced, earned or spent in a country’s economy. The most common measure of this is gross domestic product (GDP). This is calculated by adding the total value of a country's goods and services that are produced over a year.
GDP is disliked as an objective of economic policy by some because it is not a perfect measure of welfare. It fails to take into account activities from which individuals derive utility (enjoyment), but have no economic value, e.g a walk in the hills. But it does include some things that lower the quality of life (which economists call “externalities”), such as activities that damage the environment. Furthermore it fails to take account of the distribution of wealth in an economy.
Recently, some countries have started attempting to measure the welfare of citizens directly. Economists in Bhutan track ‘gross national happiness’ alongside GDP.
OPEC – the Organisation of Petroleum Exporting Countries – has historically held tight control over the world’s oil supply. The organisation was established in 1960 with the intention of ensuring that major oil companies could not cut prices without their say-so, as this could have the effect of reducing tax revenues to oil-producing countries.
More recently, OPEC has been faced with a new challenge, in the form of shale oil production in the United States and elsewhere. During 2014 and 2015, OPEC’s tactic was to ramp up production, lowering the oil price to squeeze out high-cost shale producers and maintain OPEC’s market share. Perhaps satisfied that it has been successful in this aim, as of December 2016 OPEC has agreed to cut back production in order to support oil prices.
Something that seems to be sorely lacking in many economies. Productivity measures the quantity of output that can be produced using a set amount of inputs. Rising productivity allows an economy to grow without creating inflation, and is the main long-run driver of rising living standards. Indeed, since 1850, inflation-adjusted national incomes in the UK have risen around 20-fold. In the absence of productivity growth, UK living standards today would only be around double their 1850 value – in other words, at late-Victorian levels.
More recently, the UK and other advanced economies have experienced remarkably little productivity growth – a trend that started prior to the financial crisis. This “productivity puzzle” has baffled economists. The drivers appear to be a combination of measurement error, a lack of investment, poor diffusion of innovations, and skills mismatches. Encouragingly, none of these factors are irreversible, and a suitable policy response should prevent the factors preventing productivity growth from becoming permanent.
Quantitative easing (QE) has made the extremely rare journey from the darkest depths of economic theory and textbooks to the business news. At its most simple, it is the central bank increasing the money supply. Viewed by some as an efficient way of boosting demand, others see it as nothing more than the ‘irresponsible’ printing of money. Its effects are notoriously hard to calculate, as no one can say with any real certainty what would have happened without it, i.e. what the ‘counterfactual’ of no QE would have been. Some economists think the policy has done nothing more than make the rich get richer and the poorer get poorer, as the benefits have tended to flow towards those who already possess assets. On the other hand, it may have helped avert economic Armageddon. We may never know for certain.
When economic theory is being taught, it generally starts with the classical economic assumption that we are all rational and seek to maximise our ‘utility’ – measured mathematically and logically by a hard number. The problem: we aren’t rational, or at least we don’t appear to be. The theory of ‘bounded rationality’, which forms part of behavioural economics and has gained traction in recent years, explains our apparent irrationality by suggesting that people are not always able to obtain all the information they would need to make the best possible decision.
A key building block in economic thinking. All economic students will remember from their first lesson that the intersection between supply and demand creates a ‘market clearing price’ or equilibrium price. But in the presence of market rigidities, such as sticky wages, supply and demand may not be brought into balance by price movements. Unemployment is an example of supply and demand not balancing to clear the market for labour.
Economist John Taylor first put forward his eponymous interest-rate rule back in 1993. At the most basic level, it states that central banks should change interest rates should respond to differences in inflation from its target, and output from potential output.
There is now a whole family of Taylor rules, all with subtly different terms that purport to describe central bank behaviour. In reality, setting interest rates is a more nuanced skill than simply following a formula. If Taylor’s rules had been followed, US rates would already have been increased a lot more than they have been.
Along with inflation, unemployment is the scourge of politicians and economists. A certain amount of unemployment is inevitable. This is what economists term ‘frictional’ unemployment – people who are between jobs and in the process of looking for work. Problems mainly arise in the presence of ‘cyclical’ unemployment, caused by layoffs during a recession, or ‘structural’ unemployment, which can occur when technological advances render the skills of workers obsolete or the nature of an economy changes, e.g. during the closure of coal mines in 1980s Britain.
Economists describe an economy with no cyclical unemployment as being at ‘full’ employment. When unemployment falls below the full employment level, wages tend to rise at an increasing pace, leading to higher inflation. Despite relatively low rates of unemployment in many advanced economies, we are yet to see significant pricing pressures. For this reason, data on unemployment and wages are being pored over by central banks as they try to judge the right time to raise interest rates.
For most goods and services, their price and the quantity demanded have an inverse relationship, i.e. the cheaper a good becomes, the more of it people are willing to buy. For a ‘Veblen’ good the opposite is true. This is due to what economist Thorstein Veblen termed “conspicuous consumption”. In other words, these are goods that carry some ‘snob value’ and give the consumer pleasure simply because others know the item is expensive. Veblen goods could include certain designer clothing brands, watches or sports cars.
The World Bank was set up towards the end of World War II at the Bretton Woods Conference. At first it provided loans to countries to help with post-war reconstruction and development. France was the recipient of the first loan, $250 million, to help it get back on its feet after the war. These days, the World Bank’s ambitions have become more far reaching. It is committed to alleviating worldwide poverty; it recently pledged $29 billion to developing nations to combat climate change; while it is also being called up to provide solutions to the global refugee crisis.
Everything you learned in business studies lectures at university isn’t necessarily true. This is the thinking behind the theory of ‘X-inefficiency’. It attempts to explain why the real life behaviour of companies sometimes deviates from economic theory. On the whole, this is because not everyone within every company always works as efficiently as they could. If a company’s output is the greatest it can be for a given input, it is achieving X-efficiency. By contrast, if management and workers lack the motivation to maximise output, they are X-inefficient. In an industry where a company lacks competition, e.g. an oligopoly or monopoly, then it’s often possible to get away with a bit of slacking.
Yield is the income return that an investor receives from holding an asset. The yield on a deposit in a bank account is the interest rate paid by the bank, while the yield on a stock in a company is the dividend the company pays its shareholders. One aim of quantitative easing has been to reduce the yield on government bonds in order to force investors out of bonds and into riskier and higher-yielding assets. Quantitative easing has been so successful in lowering government bond yields that some are now negative, meaning that investors must pay for the privilege of lending their money to governments.
A zero-sum game is one in which the the gain of one party in a transaction is equivalent to the other party’s loss. Gambling is a zero-sum game – you or the bookie wins a certain amount, which equates to the amount the other loses. Within economics, there was an historic belief that we lived in a zero-sum world. Some mercantilists believed that wealth, which was tied up in holdings of land and gold, could only be passed around, not expanded. But by the 19th century, the concept of comparative advantage and a growing belief in free trade demonstrated that economic interactions can result in everyone being better off, creating a ‘positive-sum game’.
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