The Complete Newbies Guide to the Economy

It’s the economy, stupid!

This was the famous campaign slogan that helped put Clinton into office in 1992. If you believe in exit polls and all the other polls out there the economy became the number one issue for the election that put Obama in office. Amazingly similar the times are to 1992.

This is your guide to the economy. It is not meant to be complete in terms of explaining everything about the economy. It is actually meant to be more of a well rounded perspective concerning the economy. So here are the economic factors you need to consider to have a complete understanding of the economy.

The Cyclical Nature of an Economy.

All economies are cyclical. Nothing is perfectly sustainable over the long run. Too many factors come into play to create what we call the economy. The economy is like a river. There is a natural ebb and flow. Boom and Bust. This is the one promise the economy has for the future. Constant Change.

Free markets are always better than controlled economies.

Why? Because history has proven time and again that trying to control an economy is a futile effort. Certain mechanics of economics are hopelessly uncontrollable. Just because the government changes one of its economic policies doesn’t mean the economy will react like it wants it to, or hopes it will.

Are we in a Recession?

If you have to ask, doesn’t that mean we are in one? Well the official definition of a recession is a decline in the Gross Domestic Product (GDP) for two or more consecutive quarters. The point here is that psychology plays just as much a factor, if not more than, the science behind modern day economics. Mass belief in the idea that we are in a recession becomes a self-fulfilling prophecy.

Banking & Economics

Individual banks don’t have much effect on the economy. If they fulfill their normal role, they are simply brokers in the larger transactions that take place in the economy. The problem begins when banks start to speculate. I talked a lot about this in my previous article, The Death of Dow Jones. In it I talked about a little Act that not many people have heard of called the Gramm-Leach-Bliley Act. This gave banks the power to expand their services into investment, commercial banking, and insurance. Giddy on this new found power, banks started making risky speculative ventures into a bunch of places they shouldn’t have went. Including, but not limited to, the sub-prime mess.

You see, the banks themselves are not totally to blame. Major shifts cause major change. Banks are already learning to return to more conservative ways. However, the damage is done, and we just have to recover from this. Once again, the cyclical nature of economies is in effect.

Investment and the Economy

If I may make the analogy, investment is the primary fuel for the economy. Or the catalyst if you will. The actual fuel for any economy is its resources: People, Material, Technology, etc. Investment is what primes the pump.

For the most part, investment follows demand. This is a good thing. Investment followed technology in the 90’s and real estate at the turn of the century. Hence the boom periods we saw. The problem with the real estate boom we saw is that much of it was false demand. Many of the people who bought houses really weren’t demanding houses. They were sold houses they really couldn’t afford. The market dictates that not much more than 50% of the households in the US are demanding homes. And renting can be the smarter option for a lot of people. Probably about 50%. 😉

Unemployment, the big kahuna.

So why does unemployment matter so much? Because it is a double edged sword. Unemployment means our human resources and capacity are not being used to their fullest extent. Most economists agree that there will always be a small percentage of unemployment because of churn in the job market. However, double digit unemployment is generally considered to be pretty bad.

Higher unemployment also means that people generally have less buying power as a whole. The less money people have to spend the less things that are bought. Buying is what economy is all about isn’t it? High growth means more people are producing and more people are buying. Unemployment causes less production and less buying. Thus the double edged sword working for or against the economy.

Where are the jobs at?

One thing everyone needs to realize about our economy is how much it is based on services. 67% of GDP comes from service industry revenue. It is yet to be seen whether this is sustainable. Because we have a service economy we have a rather large and growing trade deficit. It is fairly hard to export our services, especially because they are so expensive and localized.

Many of our best paying jobs are, or were, found in the financial industries. As many of these companies collapse, go bankrupt, or are bought up, we will see unemployment increase.

The only thing certain besides death?

Taxes. While the economy is unpredictable, taxes are predictable. The current Median Household Income is currently about $48,000 a year. If you think about it, a 1% increase or decrease in taxes equals about $480 for the year or $40 a month. 5% equals $2,400 a year and $200 a month. So depending on the percentages and the amount of income the dollar amounts can be huge.

More tax income means more and/or expanded government programs. This can be good or bad, depending on how useful and effective these programs are. More taxes means less for individuals to spend, and less for business investment. Again, it is a sword that is double edged. Knowing that the government is a large, oftentimes inefficient bureaucracy, I would say that less taxes are better for everyone because the money will be used more effectively to support the economy.

Technology, Innovation & Economics

Technology & Innovation are like the special sauce in the mix of economics. They certainly increase the volatility of the market. This can be good or bad. Technology has certainly increased our ability to produce and has brought most industrial nations to a place of relative wealth and prosperity. It has leveled the playing field. Not only between the rich and the poor, but between countries and organizations.

Organizations have gained a lot of power since the feudal age when kings and queens ruled. Now it is amazing the power organizations hold over countries. The power they have is found in their ability to make money all over the world, and spread their wealth and influence globally. Regardless of what anyone thinks, organizations are way more competitive than governments. And because of this tenacity they tend to win. Technology has brought them the means to win.

Technology has also allowed work to be done practically anywhere. In a world that is constantly in search of value, we will go where we get the most bang for our buck. If we can get it elsewhere for cheaper, why would we pay more? Outsourcing is real and is to be considered hugely affective on the economies of the world. We are unwise to fight against it.

It would be wise to use our technology to expand on the number of things we can export. This will help make the U.S. more competitive in the long run. In fact, any investment in infrastructure, expanded capacity, research & development, and training, generally lends itself to a more competitive economy.

More investment: Foreign to be exact.

Did you know foreign investors own more than half of all publicly traded U.S. Treasury Securities? Like I said, investment follows demand and goes where it can make the biggest return. The U.S. is one big consumption economy and foreign investors gladly feed the beast knowing they can get good returns.

Now here is the lesson you have all been waiting for. Supply & Demand…

Interest Rates

What do interest rates have to do with supply and demand? Let’s say you have a large pool of money to invest. You want to use this money to make good, if not great, returns. To get it moving you need to make more people willing to loan the money for some kind of investment so that you can get some kind of return. How do you do that? Lower interest rates!

So large amounts of foreign investment have kept interest rates artificially low and indirectly they keep prices low as well. How? Lower interest rates make it cheaper to produce.

The Fed is currently keeping interest rates as low as possible to keep investment going. We will see how this strategy plays out in the long run.

The Two Way Street Called Immigration

Now that we have established that people and their ability to produce is one of the major factors playing into an economy, we have to consider immigration. Population growth spurs economic growth because it creates a larger demand on resources. This is why immigration is good. It is bad when the people who immigrate put more strain on the economic system then they produce for it. These are certain things to consider both economically and politically.

As the world work force moves more toward a knowledge based economy immigration will be an even larger issue. People hold and use knowledge and take it with them wherever they go. The areas that can attract some of the brightest most productive people will obviously have a greater advantage over those that lose these knowledge workers.

The God of the Economy: Demographics

More than anything, demographics play the largest part in any economy. Whether it be local, regional, national, or international. As I just stated, people and their productive abilities are what make economies grow or shrink. And demographics are all about people.

In the US, we are quickly facing the reality of the baby boomer generation retiring and becoming more reliant on social security, health care, and other types of support. They will no longer produce anywhere near what they were producing and our economy will suffer for it.

On a world scale, India and China have a combined workforce that is ten times the size of the US workforce. As these countries become more modernized we will see massive demographic shifts. People living in these countries will have higher incomes and will start consuming more goods and services. These demographic shifts will create more demand for US products and services abroad, but increased demand may also make things more expensive and therefore unaffordable for some people in the long run.

The Conclusion

I think the most important thing to take away from this whole article is to realize that an economy is just a reflection of its people. It shows how productive they are, how value is being transferred, and how prosperity shrinks or grows.

To a large degree the economy is not controllable, because people are not controllable. We all look out for our best interests. As for worrying about the economy the way it is now, I think that is a futile effort at best. Demographics change, markets change, people change. So we need to learn to change with them.

So I believe the best thing we can do is to look more after the microeconomics of our lives (personal finance), and less after the macroeconomics of this world…

What is your perspective on the economy both before and after you read this guide? I am interested to know and have you join in the discussion.

Cheers,

Jeremy