The Little Book of Economics
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The Little Book of Economics

How the Economy Works in the Real World

Greg Ip

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The Little Book of Economics

How the Economy Works in the Real World

Greg Ip

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About This Book

An accessible, thoroughly engaging look at how the economy really works and its role in your everyday life

Not surprisingly, regular people suddenly are paying a lot closer attention to the economy than ever before. But economics, with its weird technical jargon and knotty concepts and formulas can be a very difficult subject to get to grips with on your own. Enter Greg Ip and his Little Book of Economics. Like a patient, good-natured tutor, Greg, one of today's most respected economics journalists, walks you through everything you need to know about how the economy works. Short on technical jargon and long on clear, concise, plain-English explanations of important terms, concepts, events, historical figures and major players, this revised and updated edition of Greg's bestselling guide clues you in on what's really going on, what it means to you and what we should be demanding our policymakers do about the economy going forward.

  • From inflation to the Federal Reserve, taxes to the budget deficit, you get indispensible insights into everything that really matters about economics and its impact on everyday life
  • Special sections featuring additional resources of every subject discussed and where to find additional information to help you learn more about an issue and keep track of ongoing developments
  • Offers priceless insights into the roots of America's economic crisis and its aftermath, especially the role played by excessive greed and risk-taking, and what can be done to avoid another economic cataclysm
  • Digs into globalization, the roots of the Euro crisis, the sources of China's spectacular growth, and why the gap between the economy's winners and losers keeps widening
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Chapter One

The Secrets of Success

How People, Capital, and Ideas Make Countries Rich

Pop quiz: The year is 1990. Which of the following countries has the brighter future?
The first country leads all major economies in growth. Its companies have taken commanding market shares in electronics, cars, and steel, and are set to dominate banking. Its government and business leaders are paragons of long-term strategic thinking. Budget and trade surpluses have left the country rich with cash.
The second country is on the brink of recession; its companies are deeply in debt or being acquired. Its managers are obsessed with short-term profits while its politicians seem incapable of mustering a coherent industrial strategy.
You’ve probably figured out that the first country is Japan and the second is the United States. And if the evidence persuaded you to put your money on Japan, you would have been in great company. “Japan has created a kind of automatic wealth machine, perhaps the first since King Midas,” Clyde Prestowitz, a prominent pundit, wrote in 1989, while the United States was a “colony-in-the-making.” Kenneth Courtis, one of the foremost experts on Japan’s economy, predicted that in a decade’s time it would approach the U.S. economy’s size in dollar terms. Investors were just as bullish; at the start of the decade Japan’s stock market was worth 50 percent more than that of the United States.
Persuasive though it was, the bullish case for Japan turned out completely wrong. The next decade turned expectations upside down. Japan’s economic growth screeched to a halt, averaging just 1 percent from 1991 to 2000. Meanwhile, the United States shook off its early 1990s lethargy and its economy was booming by the decade’s end. In 2000, Japan’s economy was only half as big as the U.S. economy. The Nikkei finished down 50 percent, while U.S. stocks rose more than 300 percent. Far from catching up to the United States, Japan’s economy in 2010 fell to third largest in the world, behind China’s.
What explains Japan’s reversal of fortune? Simply put, an economy needs both healthy demand and supply. As is well known, Japan’s demand for goods and services suffered when overinflated stocks and real estate collapsed, saddling companies and banks with bad debts that they had to work off. At the same time, though less well known, deep-seated forces chipped away at Japan’s ability to supply goods and services.
The supply problem is critical because in the long run economic growth hinges on a country’s productive potential, which in turn rests on three things:
1. Population
2. Capital (i.e., investment)
3. Ideas
Population is the source of future workers. Because of a low birth rate, an aging population and virtually nonexistent immigration, Japan’s working-age population began shrinking in the 1990s. A smaller workforce limits how much an economy can produce.
Capital and ideas are essential for making those workers productive. In the decades after World War II, Japan invested heavily in its human and economic capital. It educated its people and equipped them with cutting-edge technology adapted from the most advanced Western economies in an effort to catch up. By the 1990s, though, it had largely caught up. Once it had reached the frontier of technology, pushing that frontier outward would mean letting old industries die so that capital and workers could move to new ones. Japan’s leaders resisted the bankruptcies and layoffs necessary for that to happen. As a result, the next wave of technological progress, based on the Internet, took root in the United States, whose economic lead over Japan grew sharply over the course of the 1990s.

A Recipe for Economic Growth

Numerous factors determine a country’s success and whether its companies are good investments. Inflation and interest rates, consumer spending, and business confidence are important in the short run. In the long run, though, a country becomes rich or stagnates depending on whether it has the right mix of people, capital, and ideas. Get these fundamentals right, and the short-run gyrations seldom matter.
Until the eighteenth century, economic growth was so slight it was almost impossible to distinguish the average Englishman’s standard of living from his parents’.
Between 1945 and 2007 the U.S. economy went through 10 recessions yet still grew enough to end up six times larger, with the average American three times richer.
We’ve taken growth for granted for so long that we’ve forgotten that stagnation could ever be the norm. Yet, it once was. Until the eighteenth century, economic growth was so slight it was almost impossible to distinguish the average Englishman’s standard of living from his parents.’ Starting in the eighteenth century, this changed. The Industrial Revolution brought about a massive reorganization of production in England in the mid-1700s and later in Western Europe and North America. Since then, steady growth—the kind that the average person notices—has been the norm. According to economic historian Angus Maddison, the average European was four times richer in 1952 than in 1820 and the average American was eight times richer.
In the preindustrial era, China was the world’s largest economy. Its modest standard of living was on a par with that of Europe and the United States. But China then stagnated under the pressure of rebellion, invasion, and a hidebound bureaucracy that was hostile to private enterprise. The average Chinese was poorer in 1952 than in 1820.
So 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.
The total output a country can produce given its labor force and its productivity is called potential output, and the rate at which that capacity grows over time is potential growth. So if the labor force grows 1 percent a year and its productivity by 1.5 percent, then potential growth is 2.5 percent. Thus, an economy grows.

Take a Growing Population

Let’s recap. An economy needs workers to grow. And, usually, the higher the population, the higher the number of potential workers. Population growth depends on a number of factors including the number of women of child-bearing age, the number of babies each of those women has (the fertility rate), how long people live, and migration.
In poor countries, many children die young so mothers have more babies. As countries get richer and fewer children die, fertility rates drop and, eventually, so does population growth. As women have fewer children, more of them go to work. This demographic dividend delivers a one-time kick to economic growth. For example, it was a major contributor to East Asia’s growth from the 1960s onward and to China’s after the introduction of its one-child policy in 1979. But a country only gets to cash in its demographic dividend once. Eventually, as population growth slows, it ages and each worker must support a growing number of retirees. If fertility drops much below 2.1 babies per woman, the population will shrink unless offset by immigration.
Japan is not the only country to have experienced this; 40 percent of countries now have fertility rates below 2.1, including Korea and Brazil. In some, including Russia and Germany, population is already shrinking. The most dramatic example is China where the one-child policy and, more recently, increasing wealth and urbanization have brought the fertility rate down dramatically to just 1.6. In Shanghai, China’s wealthiest big city, it’s 0.6, one of the lowest in the world. In 2026, China’s population should start to decline. It may be the first country to grow old before it grows rich.

Add Capital

A country is not rich, though, just because it has a lot of people—just look at the Philippines, which has 21 times as many people as Ireland but an economy of roughly equal size.
The reason for this population/economic size disparity is that the average Filipino is much less productive than the average Irishman. For a country to be rich—that is, for its average citizen to enjoy a high standard of living—it must depend on productivity, which is the ability to make more, better stuff with the labor it already has.
Productivity itself depends on two factors: capital and ideas.
You can raise productivity by equipping workers with more capital, which means investing in land, buildings, or equipment. Give a farmer more land and a bigger tractor or pave a highway to get his crops to market, and he’ll grow more food at a lower cost. Capital is not free, though. A dollar invested to produce more stuff tomorrow is a dollar not available to spend on stuff today. Thus, for someone to invest a dollar, someone else must save a dollar; and so a key ingredient of growth is saving. That saving can come from households, businesses, foreigners, even governments, although most governments borrow rather than save, as we see in Chapter 14. The more a society saves, the more capital it can accumulate. (There is, however, such a thing as saving too much, as we learn in Chapter 11.)
Capital, though, will only take a country so far. Just as your second cup of coffee will perk you up less than your first, each additional dollar invested provides a smaller boost to production. A farmer’s second tractor will help his productivity far less than his first. This is the law of diminishing returns.

Season with Ideas

How do you repeal the law of diminishing returns? With ideas. In 1989, Greg LeMond put bars on the front of his bicycle that enabled him to ride in a more aerodynamic position. This simple idea sliced seconds off his time, allowing him to beat Laurent Fignon and win the Tour de France.
New ideas transform economic production the same way. By combining the capital and labor we already have differently, we can produce new or better products at a lower cost. “Economic growth springs from better recipes, not just from more cooking,” says Paul Romer, a Stanford University economist. For example, DuPont’s discovery of nylon in the 1930s transformed textile production. These man-made fibers could be spun at far higher speeds and required far fewer steps than cotton or wool. Combined with faster looms, textile productivity has soared, and clothes have gotten cheaper and better.
The productive power of ideas is nothing short of miraculous. Investing in more buildings and machines costs money. But a new idea can be reproduced endlessly for free.
The productive power of ideas is nothing short of miraculous. Investing in more buildings and machines costs money. But a new idea can be reproduced endlessly for free. Just as other cyclists quickly copied Greg LeMond’s aerobars, companies catch up to their competitors by copying their ideas. Although this can be frustrating for the person who came up with the idea, it’s great for the rest of us as we benefit from the improvements made with the existing idea. Here are a few examples:
  • New business processes. Some of the most powerful ideas involve rearranging how a company runs itself. In 1776, in the first chapter of The Wealth of Nations, Adam Smith marveled how an English factory divides pin making into 18 different tasks. Smith calculated that one worker, who could by himself make one pin a day, could now make 4,000. “The division of labor occasions, in every art, a proportionable increase in the productive powers of labor,” he wrote. Two centuries later Walmart revolutionized retailing by using big box stores, bar codes, wireless scanning guns, and exchanging electronic information with its suppliers to track and move goods more efficiently while scheduling cashiers better to reduce slack time. As competitors like Target and Sears copied Walmart, customers of all three benefited from lower prices and more selection, a McKinsey study found.
  • New products. Netscape’s Navigator was the first commercially successful browser but was soon supplanted by Microsoft’s Internet Explorer, which is now under siege by Mozilla Firefox, Apple Safari, and Google Chrome. Browsers keep getting better but consumers still pay the same price, zero. Drugs provide another example. Eli Lilly’s introduction of the antidepressant Prozac in 1986 inspired competitors to develop similar drugs like Zoloft and Celexa, providing alternatives for patients who didn’t respond well to Prozac.1
Ideas can be patented, or copyrighted. But overly restrictive patents and copyrights discourage the spread of ideas and leave society worse off. A lot fewer books would have been written if the estate of Johannes Gutenberg collected a fee on every one.
It’s not just companies that thrive by imitating their competitors. Entire countries can turbocharge their development by strategically copying the ideas and technologies that other countries already use. Eckhard Höffner, an economic historian, attributes Germany’s rapid industrial development in the nineteenth century to weak copyright laws, which encouraged publishers to flood the country with cheap (and often plagiarized) copies of essential technical manuals. Japanese steelmakers didn’t invent the basic oxygen furnace; they adapted it from a Swiss professor who had devised it in the 1940s. They thus leapfrogged U.S. steelmakers who were using less efficient open-hearth furnaces. Japan’s mainframe computer makers benefited from a government edict that IBM make its patents available as a condition of doing business there.
More recently, China’s adaptation of existing ideas from other countries has resulted in significant economic growth. Since 1978, it has moved workers from unproductive farms and state-owned companies to more productive ...

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Citation styles for The Little Book of Economics
APA 6 Citation
Greg. (2012). The Little Book of Economics (2nd ed.). Wiley. Retrieved from (Original work published 2012)
Chicago Citation
Greg. (2012) 2012. The Little Book of Economics. 2nd ed. Wiley.
Harvard Citation
Greg (2012) The Little Book of Economics. 2nd edn. Wiley. Available at: (Accessed: 14 October 2022).
MLA 7 Citation
Greg. The Little Book of Economics. 2nd ed. Wiley, 2012. Web. 14 Oct. 2022.