Economics: The Basics
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Economics: The Basics

Tony Cleaver

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eBook - ePub

Economics: The Basics

Tony Cleaver

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About This Book

Now in its third edition, Economics: The Basics continues to provide an engaging and topical introduction to the key issues in contemporary economics. Fully updated to take into account the global recession, ongoing problems in Eurozone economies, changing patterns in world trade, housing and currency markets, it covers fundamental issues, including:

• How different economic systems function

• The boom and bust cycle of market economies

• The impact of emerging markets

• How price, supply and demand interact

• The role of the banking and finance industry

• Whether we can emerge from recession and reduce poverty

• The impact of economics on the environment

With a glossary of terms, suggestions for further reading and new case studies covering subjects such as the choices facing developing economies, the impact of growth on the price of natural resources and the aftermath of the financial crash; this comprehensive and accessible guide is essential reading for anyone who wants to understand how economics works.

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You cannot make a lot sense of what goes on in the world without some knowledge of basic economics.
In my own lifetime, three major upheavals have shaken the world order to its very roots: the oil price shocks of the 1970s; the collapse of the centrally planned economies at the end of the 1980s, and now a widespread and long-lasting recession that is currently depressing the incomes of billions of people around the globe.
Quite apart from sudden cataclysmic shocks like these, there are also any number of other issues – some growing in importance with a slow burn, others just a dull persistent ache that never goes away – that demand our attention and understanding. All have important economic dimensions: climate change, bank panics, health care, world poverty, immigration, educational reform, even overseas military engagements … the list is endless.
To fully understand the implications of these and many other issues requires serious, though not very difficult, economic analysis.
The aim of this text, dear reader, is thus to give you some insight into how some of these complex issues can be unravelled, how economics works and contributes to a balanced appraisal of controversial and contemporary affairs, and therefore how your own opinions can be better informed.
Let me say right here that economics is supposed to be value-free. Economists don’t make the decisions, do not attempt to persuade; they are merely social scientists typically claiming to set out a dispassionate analysis of social phenomena, laying out the costs and benefits on either side, clarifying the assumptions and logic involved and thus allowing others to make their minds up. That is the intention, anyway! My apologies if you detect any undeclared biases.
You might be forgiven for thinking that economics is all about money. It is a popular misconception. Economics, in fact, is about analysing choices. What is the most economic course of action, given that resources are scarce and there are a number of possible options over how to employ them? Should governments provide better health care for their electorate, or invest more in the armed services and counter-terrorism? Should public money be used to bail out failing banks and what happens if not? Should drug companies pour more research into the causes of and remedies for flu pandemics or AIDS? Should you and I buy more food, clothes or electronic gadgetry?
Prior to making such choices we need to evaluate the alternatives. Economists use money as the measuring stick. Some people wrongly assume therefore that economics is only interested in what makes a profit … but that is to confuse the aims of commercial business with the academic process of estimating economic costs and benefits. Should we build cheap, coal-fired power stations that pollute the planet, or less environmentally damaging but more expensive wind or thermal powered generators? A businessman with no restriction imposed by the state may choose the former option. Should the state intervene in this decision? An objective economist would want to calculate the costs to the planet of carbon emissions from low-tech, coal-fired power plants and then convert these environmental costs into monetary values on the way to measuring the real costs and benefits of the alternative strategies. Which power plant in which place is “best”? How do we define and measure that? Economics is about money – but as a means, not an end.
It is particularly when businesses lose money and people lose employment through no fault of their own that economists can be asked to explain what is going on. That was certainly the case in the Great Depression era of the 1930s when an unprecedented slump in trade destroyed the jobs, incomes and hopes of many innocent victims worldwide. At the time, in 1936, a brilliant economist and policy advisor – John Maynard Keynes – responded with a revolutionary analysis of the causes and possible remedies of the international crash that is in many important respects still relevant today. And sure enough, today, governments, businessmen, journalists and ordinary people affected by the current global economic downturn are again asking the same questions about what happened; why; who is to blame, and how do we get out of this mess?
We can use the example of the causes and ramifications of the present international slowdown as an introduction to basic economics. Critics might claim that this is a tough challenge. It is a bit like that old joke of the driver who gets hopelessly lost and pulls over to ask a local what is the best way to get to his destination. The reply comes: “Oh, aarh … that’s difficult. I wouldn’t want to start from here…”
Nevertheless we are in the world where we are. Stuck in a complex mess that people generally want to understand. Just what are the precise reasons for the constrained economic circumstances we currently find ourselves in? How did we get in and how do we get out? It is a fascinating story that embraces both slow-moving, worldwide fundamental forces and more proximate, easily recognised foibles of specific time and place. Let us take up the challenge…
It is popularly held that it all started in the USA in 2007 with what is known as the “sub-prime mortgage crisis”. This was the pricking of a bubble in house prices when a decade of steadily rising property prices was suddenly reversed.
The USA is a prime example of a market economy and as such – like all market systems – it is driven more by popular demand than by government diktat. Indeed, due to its unique history and traditions, there is probably a more active and pervasive distrust of centralised government in the USA than is the case in Europe and in most other developed nations. It was the increasing demand for home loans and the all-to-easy willingness of financiers to provide those loans, unrestricted by any central authority, which drove up house prices throughout the boom years of the 1990s. Both consumers and producers of this rapid expansion of US finance were too caught up in the enjoyment of inflated wealth to consider the longer-term picture.
Taking a longer view, however, we can see that all market systems are chronically unstable. For reasons that are still the cause of much argument, market economies are prone to cyclical booms and slumps and it was the false pride of many, outside as well as inside the USA, which led many to believe that in the 1990s we could escape this cycle.
The reality, as illustrated in Figure 1.1, is different. Considering only the period since the Second World War (that is, not even considering the enormous swings in economic fortunes caused by two world wars and an intervening Great Depression) the rate of economic growth of US gross domestic product (GDP) shows almost regular ups and downs.
Figure 1.1 Percentage change in US GDP, 1950–2012. (Source: US Bureau of Economic Analysis.)
A little explanation is called for: the 1950s was a decade of readjustment to life after one (world) war and during another (Korea) and thus accounts for a very variable growth record. The 1960s saw steady and positive growth as the US consolidated its position as the powerhouse of the Western world. The major oil shock of 1973–74 can be clearly identified with negative growth as large payments to the Organization of Petroleum Exporting Nations (OPEC) were called for, repeated again at the beginning of the 1980s with the second oil price shock. After a brief hiccup in 1991, steady growth occurred (called “The Great Moderation”) through the 1990s and into the new millennium (with a minor “dot-com” blip) leading to many observers thinking that cyclical ups and downs had been beaten … until we run into the biggest downturn since the Great Depression from 2007 onwards. In memory of that major interwar slump, the developed world’s current difficulty has been named the Great Recession.
Keynes called it “animal spirits”; Alan Greenspan, former chairman of the US Federal Reserve (the US central bank), called it “irrational exuberance”. But whether it is the short time horizons of people who want to get rich quick; the infectiousness of group euphoria, or maybe that technological inventiveness itself follows the same cycle and blinds people who are caught up in it … whatever the reasons, market participants seem unable to avoid the herd-like behaviour that produces periods of over-indulgence and a rapid growth in asset prices, only to be followed some time later by a sudden collapse in confidence, prices and incomes.
Figure 1.2 Percentage change in GDP, 2004–2012, Greece, Italy, Spain. The picture for Europe is not so very different from the USA until 2009 – and then the absence of European recovery is painfully obvious. This illustrates the Great Recession for three badly affected countries: A “double dip” for Italy and Spain who struggle to escape negative growth and prolonged, unrelenting misery for Greece. (The data for unemployment is an even more stark illustration of the Great Recession: steadily increasing from the onset of the crisis in 2007, unemployment at the end of 2013 was for Italy: 12.2%; Spain: 26.2%; Greece: 27.6%. These are figures comparable to the worst of the1930s.) (Source: World Bank.)
The boom and bust in the US housing market, whilst undeniably a calamity for those involved, could not have been the tipping point for the international recession that followed, however, without a conjunction of a number of other factors operating over different periods in space and time. The most fundamental of these are the deep undercurrents that have been swirling away since the other two major upheavals in the world economy that occurred in the 1970s and late 1980s, mentioned earlier.
The first of these were the oil price shocks of 1973 and 1979. They emphasised how dependent the developed world is on imported petroleum, so causing a substantial redistribution of world incomes as consuming nations had to pay the higher prices that producers in the Middle East and elsewhere were demanding. Since the 1970s, the accumulation of REVENUES by the OPEC nations has varied over time in line with world oil prices and that in turn has given rise to the search for investment outlets – petrodollar recycling – as the capacity of those countries to spend such windfall riches has not always been able to keep pace.
The other world-changing event was the demise of the world’s major command economies and their transformation into market systems. For China this was a gradual process of economic resurgence during the 1980s and thereafter, not accompanied (as yet!) by any radical change in political leadership. For the former Soviet Union and its Eastern European satellites it was a sudden, revolutionary change in capital ownership and control effected in and around 1989.
Add these two factors to too-clever financial wizardry that thought it had the world by the tail and we have a story of selfish greed, blindness, pride, bankruptcies, bail-outs, debt and depression.
We can track the path to the Great Recession directly from the late 1990s and a series of financial crises that hit East Asia in 1997 and then prompted the Russian rouble collapse in August 1998 (mainly due to investor doubts over the Yeltsin government’s ability to manage a struggling transition economy). The clear message here was that the financial institutions of countries previously thought to be reliably based on either superstar growth (Korea, Thailand) or rich resources (Russia) were in fact dangerously vulnerable.
Add this notion to the economic realities of the new millennium: the economic growth of the most populous country on the planet was surging, creating an enormous demand for mineral resources to fuel its industry and, at the same time, much of the developed world was buying the cheap manufactured goods that China was exporting. Chinese trade surpluses were thus fast piling up, as were OPEC’s again. Billions and billions of dollars were flowing into these countries’ coffers, so where was the best place to put all these monies? Not in Russian nor East Asian banks, clearly, and the financial sector in China had not reached anywhere near the size and level of development as its manufacturing industry. The only place to pour them would be into the biggest possible pool of assets where those dollars would keep their value and hopefully cause the least disruptive splash, i.e. in the US money markets.
There are a number of ways of measuring the massive flows of wealth that were travelling around the world over this period and the impact these movements were having. Figure 1.3 first shows the growth in Chinese exports compared to those of the USA and the UK. Using the year 2000 as the base year, it can be seen that Chinese exports increased by over 500 per cent in the period 1998–2007, whereas the UK and the USA barely saw a 50 per cent increase.
Figure 1.3 Growth in value of exports, China, USA and UK, 1998–2007. (Source: World Bank.)
Figure 1.4 shows the trade balance for various countries in a single year: 2008. There are massive surpluses for the OPEC countries (Algeria, Angola, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates and Venezuela) and China; with slightly less for Germany and Japan (two other export-based economies). These are contrasted with countries that have been importing far more than they have exported and thus have run up large deficits … none larger than the unequalled negative balance of the USA.
Figure 1.4 Current Account Balance, various countries, 2008 (US$ billions). (Source: IMF.)
Figure 1.5 US Government Debt (US$ billions). (Source: IMF.)
These graphs give you some idea of the large amounts of money that were changing hands in exchange for exports of petroleum products and manufactures. Figure 1.5 shows where a lot of that money then ended up – recycled back into deposits in the USA! Because those countries with large trade surpluses were earning so much more than they were able to spend, they had to put the dollars they earned somewhere … and that somewhere was in US government bonds and TREASURY BILLS. No other store of value was reliable and plentiful enough to soak up all that money. In 2008, therefore, over ten trillion dollars worth of assets were held by creditors inside and outside the USA.
Now this is where the story gets really interesting. All this cash pouring into the USA for over a decade was not just sitting there. US bonds and bills are like bread and butter to the money markets. They are in fact US government IOUs that are 100 per cent reliable and promise to pay you a steady stream of interest. As valuable assets, you can readily sell them on at any time to all manner of financial traders if you don’t want to wait until the IOU eventually falls due. In this way, government securities become just the seed capital that forms the base for a huge expansion of subsequent money making.
All banks and finance houses are in the business of making money. In fact, as is explained in a later chapter, bankers can offer loans to as many people and businesses as they want to or consider safe – even though they may have very little cash at all in their own vaults. So, as customers deposit bills, bonds and other liquid assets into their bank accounts, it allows the managers of those accounts to create money, that is, to loan out sums to a far greater multiple than they actually hold. It is a numbers game. If you reckon...

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