Regulation

Rules governing the activities of private-sector enterprises. Regulation is often imposed by government, either directly or through an appointed regulator. However, some industries and professions impose rules on their members through self-regulation.
Regulation is often introduced to tackle market failure. Externalities such as pollution have inspired rules limiting factory emissions. Regulations on the selling of financial products to individuals have been introduced as protection against unscrupulous financial firms with better information than their customers. Rate of return regulation and price regulation have been used to combat natural monopoly, sometimes instead of nationalization. Some regulation has been motivated by politics rather than economics, for instance, restrictions on the number of hours people can work or the circumstances in which an employer can dismiss employees.
Even when introduced for sound economic reasons, regulation can generate more costs than benefits. Regulated firms or individuals may face substantial compliance costs. Firms may devote substantial resources to regulatory arbitrage, which would leave consumers no better off. Regulation may lead to moral hazard if people believe that the government is keeping an eye on the behaviour of the regulated business and so do less monitoring of their own. Regulation may be badly designed and thus lock an industry into an inefficient equilibrium. Rigid regulation may hold back innovation. There is also the danger of regulatory capture. In short, then, regulatory failure may be even worse for an economy than market failure.

Regulatory arbitrage

Exploiting loopholes in regulation, and perhaps making the regulation useless in the process. This is often done by international investors that use derivatives to find ways around a country’s financial regulations.

Regulatory capture

Gamekeeper turns poacher or, at least, helps poacher. The theory of regulatory capture was set out by Richard Posner, an economist and lawyer at the university of Chicago, who argued that “regulation is not about the public interest at all, but is a process, by which interest groups seek to promote their private interest ... Over time, regulatory agencies come to be dominated by the industries regulated.” Most economists are less extreme, arguing that regulation often does good but is always at risk of being captured by the regulated firms.

Regulatory failure

When regulation generates more economic costs than benefits.

Regulatory risk

A risk faced by private-sector firms that regulatory changes will hurt their business. In competitive markets, regulatory risk is usually small. But in natural monopoly industries, such as electricity distribution, it may be huge. To ensure that regulatory risk does not deter private firms from offering their services, a government wishing to change its regulations may have good reason to compensate private firms that suffer losses as a result of the change.

Relative income hypothesis

People often care more about their relative well being than their absolute well being. Someone who prefers a $100 a week pay rise when a colleague gets $50 to both of them getting a $200 increase, for example. Poor people may consume more of their income than rich people do because they want to reduce the gap in their consumption levels. The relative income hypothesis, set out by James Duesenberry, says that a household’s consumption depends partly on its income relative to other families. Contrast with permanent income hypothesis.

Rent

Confusingly, rent has two different meanings for economists. The first is the commonplace definition: the income from hiring out land or other durable goods. The second, also known as economic rent, is a measure of market power: the difference between what a factor of production is paid and how much it would need to be paid to remain in its current use. A soccer star may be paid $50,000 a week to play for his team when he would be willing to turn out for only $10,000, so his economic rent is $40,000 a week. In perfect competition, there are no economic rents, as new firms enter a market and compete until prices fall and all rent is eliminated. Reducing rent does not change production decisions, so economic rent can be taxed without any adverse impact on the real economy, assuming that it really is rent.

Rent-seeking

Cutting you a bigger slice of the cake rather than making the cake bigger. Trying to make more money without producing more for customers. Classic examples of rent-seeking, a phrase coined by an economist, Gordon Tullock, include:
• A protection racket, in which the gang takes a cut from the shopkeeper’s profit;
• A cartel of firms agreeing to raise prices;
• A union demanding higher wages without offering any increase in productivity;
• lobbying the government for tax, spending or regulatory policies that benefit the lobbyists at the expense of taxpayers or consumers or some other rivals.
Whether legal or illegal, as they do not create any value, rent-seeking activities can impose large costs on an economy.

Replacement cost

What it would cost today to replace a firm’s existing assets.

Replacement rate

The fertility rate required in a country to keep its population steady. In rich countries, this is usually reckoned to be 2.1 children per woman, the extra 0.1 reflecting the likelihood that some children will die before their parents. In poorer countries with higher infant mortality, the replacement rate may be much higher. In many countries, since the early 1990s the fertility rate has fallen below the replacement rate. There has been much debate about why, and much agreement that, if this trend continues, those countries may face long-term problems such as a relatively growing proportion of retired older people having to be supported by a relatively shrinking proportion of younger people.

Repo

Agreements in which one party sells a security to another party and agrees to buy it back on a specified date for a specified price. Central banks deal in short-term repos to provide liquidity to the financial system, buying securities from banks with cash on the condition that the banks will repurchase them a few weeks later.

Required return

The minimum expected return you require from an investment to be willing to go ahead with it.

Rescheduling

Changing the payment schedule for a debt by agreement between borrower and lender. This is usually done when the borrower is struggling to make payments under the original schedule. Rescheduling can involve reducing interest ¬payments but extending the period over which they are collected; putting back the date of repayment of the loan; reducing interest payments but increasing the amount that has to be repaid eventually; and so on. The rescheduling may or may not require the lender to bear some financial loss. The rescheduling may or may not require the lender to bear some financial loss. The rescheduling of loans to countries usually takes place through the Paris club and London club.

Reservation wage

The lowest wage for which a person will work.

Reserve currency

A foreign currency held by a government or central bank as part of a country’s reserves. Outside the United States the dollar is the most widely used reserve currency. Everywhere the euro is increasingly widely used.

Reserve ratio

The fraction of its deposits that a bank holds as reserves.

Reserve requirements

Regulations governing the minimum amount of reserves that a bank must hold against deposits.

Reserves

Money in the hand, available to be used to meet planned future payments or if some other need arises. Firms may put their reserves in a bank, as a deposit. For a bank, reserves are those deposits it retains rather than lending them out.

Residual risk

When you buy an asset you become exposed to a bundle of different risks. Many of these risks are not unique to the asset you own but reflect broader possibilities, such as that the stock market average will rise or fall, that interest rates will be cut or increased, or that the growth rate will change in an entire economy or industry. Residual risk, also known as alpha, is what is left after you take out all the other shared risk exposures. Exposure to this risk can be reduced by diversification. Contrast with systematic risk.

Returns

The rewards for doing business. Returns usually refer to profit and can be measured in various ways

Revealed preference

An example of a popular joke among economists: two economists see a Ferrari. “I want one of those,” says the first. “Obviously not,” replies the other. To get a smile out of this it is necessary (but not, alas, sufficient) to know about revealed preference. This is the notion that what you want is revealed by what you do, not by what you say. Actions speak louder than words. If the economist had really wanted a Ferrari he would have tried to buy one, if he did not own one already.
Economists have three main approaches to modeling demand and how it will change if prices or incomes change.
• the cardinal approach involves asking consumers to say how much utility they get from consuming a particular good, aggregating this across all goods and services, and calculating how demand would change on the assumption that people will consume the combination of things that maximizes their total utility.
• The ordinal approach does not require consumers to say how much utility they get in absolute terms from consuming a particular good. Instead, it asks them to indicate the relative utility they get from consuming one item compared with another that is, to say if they prefer one basket of goods to another, or are indifferent between them.
• The third approach is revealed preference. To model demand it is only necessary to be able to compare an individual’s consumption decisions in situations with different prices and/or incomes and to assume that consumers are consistent in their decisions over time (that is, if they prefer wine to beer in one period they will still prefer wine in the next).

Ricardo, David

The third of 17 children of a wealthy banker, David Ricardo (1772–1823) was disinherited at the age of 21 after he married a Quaker against the wishes of his parents. He became a stockbroker and did so well that he retired at 42 to concentrate on writing and politics.
A friend of fellow classical economists Thomas Malthus and jean-Baptist say (see say's law), he developed many economic theories that are still in use today. The most influential was comparative advantage, the theory underpinning the case for free trade. In his 1817 book, the principles of political economy and taxation, he outlined a theory of distribution of output in an economy. In this he argued that the allocation of factors of production to any area of economic activity is determined by the level of economic rent that can be earned from it. As this gradually falls because of diminishing returns, capital and other resources shift to more profitable projects. He examined the split between wages and profit, arguing that “there can be no rise in the value of labor without a fall of profits”. He also claimed that changes in the government deficit did not affect the level of demand in the economy.

Risk

The chance of things not turning out as expected. Risk taking lies at the heart of capitalism and is responsible for a large part of the growth of an economy. In general, economists assume that people are willing to be exposed to increased risks only if, on average, they can expect to earn higher returns than if they had less exposure to risk. How much higher these expected returns need to be depends partly on the probability of an undesirable outcome and partly on whether the risk taker is risk averse, risk neutral or risk seeking.
During the second half of the 20th century, economists greatly improved their understanding of risk and developed theories of risk management, which suggest when it makes sense to use insurance, diversification or hedging to change risk exposures.
In financial markets the most commonly used measure of risk is the volatility (or standard deviation) of the price of, or more appropriately the total returns on, an asset. Often added to the risk profile are other statistical measures such as skewness and the possibility of extreme changes on rare occasions.

Risk averse

Someone who thinks risk is a four-letter word. Risk-averse investors are those who, when faced with two investments with the same expected return but two different risks, prefer the one with the lower risk.

Risk management

The process of bearing the risk you want to bear, and minimizing your exposure to the risk you do not want. This can be done in several ways: not doing things that carry a particular risk; hedging; diversification; and buying insurance.

Risk neutral

Someone, who is insensitive to risk. Risk-neutral investors are indifferent between an investment with a certain outcome and a risky investment with the same expected returns but an uncertain outcome. Such people are few and far between.

Risk premium

The extra return that investors require to hold a risky asset instead of a risk-free one; the difference between the expected returns from a risky investment and the risk-free rate.

Risk seeking

Someone, who cannot get enough risk. Risk-seeking investors prefer an investment with an uncertain outcome to one with the same expected returns and certainty that it will deliver them.

Risk-free rate

The rate of return earned on a risk-free asset. This is a crucial component of modern portfolio theory, which assumes the existence of both risky and risk-free assets. The risk-free asset is usually assumed to be a government bond, and the risk-free rate is the yield on that bond, although in fact even a treasury is not entirely without risk. In modern portfolio theory, the risk-free rate is lower than the expected return on the risky asset, because the issuer of the risky asset has to offer risk averse investors the expectation of a higher return to persuade them to forgo the risk-free asset.

Safe harbour

Protection from the rough seas of regulation. Laws and regulations often include a safe harbour clause that sets out the circumstances in which otherwise regulated firms or individuals can do something without regulatory oversight or interference.

Satisficing

Settling for what is good enough, rather than the best that is possible. This may occur in any situation in which decision makers are trying to pursue more than one goal at a time. Classical economics and Neo-classical economics assume that individuals, firms and governments try to achieve the optimum, best possible outcome from their decisions. Satisficing assumes they decide for each goal a level of achievement that would be good enough and try to find a way to achieve all of these sub-optimal goals at once. This approach to decision making is commonplace in behavioral economics. It can be regarded as a realist’s theory of how decisions are taken. The concept was invented by Herbert Simon (1916-2001), a Nobel ¬prize-winning economist, in his book, models of man, in 1957.

Savings

Part of income that is not spent is called income. Ultimately, savings are the source of investment in an economy, although domestic savings may be supplemented by capital from foreign savers or themselves be invested abroad.
In an economic sense, savings include purchases of shares or other financial securities. However, many official measures of a country’s savings ratio--total savings expressed as a percentage of total income--leave out such financial transactions. At times when the demand for financial securities is unusually high, this can give a misleading impression of how much saving is taking place.
How much individuals save varies significantly among different age groups (see life-cycle hypothesis) and nationalities. Everywhere, people of all ages save more as their income rises. The supply of savings rises when interest rates rise; a rise in interest rates causes demand for funds to invest to fall; a rise in demand for investment funds may cause interest rates, and thus the cost of capital, to rise. The level of savings is also influenced by changes in wealth (see wealth effect) and by taxation policies.

Say's law

Supply creates its own demand. So, argued a French economist, Jean-Baptist say (1767–1832), and many classical and Neo-classical economists since. Keynes argued against say, making the case for the use of fiscal policy to boost demand if there is not enough of it to produce full employment.

Scalability

The ease with which the supply of an economic product or process can be expanded to meet increased demand. Recent technological advances have led some economists to talk about the growing importance of instant scalability. For example, once a piece of software has been written it can be made available in an instant over the internet to unlimited numbers of users for almost no cost. This potentially allows a new product to enter and win market share far more quickly than ever before, intensifying competition and perhaps accelerating the process of creative destruction

Scarcity

Supplies of the factors of production are not unlimited. This is why choices have to be made about how best to use them, which is where economics comes in. Market forces operating through the price mechanism usually offer the most efficient way to allocate scarce resources, with government planning playing at most a minor role. Scarcity does not imply poverty. In economic terms, it means simply that needs and wants exceed the resources available to meet them, which is as common in rich countries as in poor ones.

Scenario analysis

Testing your plans against various possible scenarios to see what might happen should things not go as you hope. Scenario analysis is an important technique in risk management, helping firms and especially financial institutions to ensure that they do not take on too much risk. Its usefulness does of course depend on risk managers coming up with the right scenarios.

Schumpeter, Joseph

After growing up in the Austro-Hungarian empire, in which he worked as an itinerant lawyer, Joseph Schumpeter (1883–1950) became an academic in 1909. He was appointed austrian minister of finance in 1919, presiding over a period of hyper-inflation. He then became president of a small Viennese bank, which collapsed. He returned to academia in bonn in 1925 and in the 1930s joined the faculty of Harvard.
In 1911, while teaching at Czernowitz (now in Ukraine), he wrote the theory of economic development. In this he set out his theory of entrepreneurship, in which growth occurred, usually in spurts, because competition and declining profit inspired entrepreneurs to innovate. This developed into a theory of the trade cycle (see business cycle), and into a notion of dynamic competition characterized by his phrase “creative destruction”. In capitalism, he argued, there is a tendency for firms to acquire a degree of monopoly power. At this point, competition no longer takes place through the price mechanism but instead through innovation. Perhaps because monopolies often become lazy, successful innovation may come from new entrants to a market, who takes it away from the incumbent, thus blowing “gales of creative destruction” through the economy. Eventually, the new entrants grow fat on their monopoly profits, until the next gale of creative destruction blows them away.
Ever controversial, and often wrong, in his 1942 book, capitalism, socialism and democracy, he predicted the downfall of capitalism at the hands of intellectual elite. He is associated with both Austrian economics and, arguably as founding father, evolutionary economics.

SDR

Short for Special Drawing Rights. Created in 1967, the SDR is the IMF's own currency. Its value is based on a portfolio of widely used currencies.

Search costs

The cost of finding what you want. The economic cost of buying something is not simply the price you pay. Finding what you want and ensuring that it is competitively priced can be expensive, be it the financial cost of physically getting to a marketplace or the opportunity cost of time spent fact-finding. Search costs mean that people often take decisions without all the relevant information, which can result in inefficiency. Technological changes such as the internet may sharply reduce search costs, and thus lead to more efficient decision making.

Seasonally adjusted

There are seasonal patterns in many economic activities; for instance, there is less construction in winter than in summer, and spending in shops soars as christmas approaches. To reveal underlying trends, statistics reflecting only part of the year are often adjusted to iron out seasonal variations.

Second-best theory

As we do not live in a perfect world, how useful is economic theories based on the assumption that we do? Second-best theory, set out in 1956 by Richard lapse and Kelvin Lancaster (1924–99), looks at what happens when the assumptions of an economic model are not fully met. They found that in situations where not all the conditions are met, the second-best situation – that is, meeting as many of the other conditions as possible – may not result in the optimum solution. Indeed, reckoned lapse and Lancaster, in general, when one optimal equilibrium condition is not satisfied all of the other equilibrium conditions will change.
Potentially, the second-best equilibrium may be worse than a new equilibrium brought about by government intervention, either to restore equilibrium to the market that is in disequilibrium, or to move the other markets away from their second-best conditions.
Economists have seized on this insight to justify all sorts of interventions in the economy, ranging from taxing certain goods and subsidizing others to restricting free trade. Whenever there is market failure, second-best theory says it is always possible to design a government policy that would increase economic welfare. Alas, the history of government intervention suggests that although the second best may be improved on in theory, in practice second best is often least worst.

Secondary market

A market in second-hand financial instruments. Bonds and shares are first sold in the primary market, for instance, through an initial public offering. After that, their new owners often sell them in the secondary market. The existence of liquid secondary markets can encourage people to buy in the primary market, as they know they are likely to be able to sell easily should they wish.

Securities

Financial contracts, such as bonds, shares or derivatives, that grant the owner a stake in an asset. Such securities account for most of what is traded in the financial markets.

Securitization

Turning a future cash flow into tradable, bond-like securities. Creating such asset-backed securities became a lucrative business for financial firms during the 1990s, as they invented new securities based on cash flow ranging from future mortgage and credit-card payments to bank loans, movie revenue and even the royalties on songs by David bowie (so-called bowie-bonds). Securitization has many benefits, at least in theory. Issuers gain instant access to money for which they would otherwise have to wait months or years, and they can shed some of the risk that their expected revenue will not materialize. By selling securitized loans, investment banks are able to finance their customers without tying up large amounts of capital. Investors can hold a new sort of asset, less risky than unsecured bonds, giving them the risk-reducing benefit of diversification. But there are dangers. The future cash flow underlying the securities may flow earlier or later than promised, or not at all.

Seignorage

Traditionally, the profit rulers made from allowing metals to be turned into coins. Now it refers in a loosely defined way to the power of a country whose notes and coins are held by another country as a reserve currency.

SENIORITY

The order in which creditors are entitled to be repaid. In the event of a bankruptcy, senior debt must be paid off before junior debt. Because junior debt has a lower chance of being repaid than senior debt, it carries more risk, and thus typically pays a higher yield.

SEQUENCING

Shorthand for implementing economic reforms in the right order. In recent years, this has become a hot topic in development economics. Some economists argue that introducing the right policies alone is not enough to revive a malfunctioning economy; reforms must be implemented in the right sequence. Thus they debate when in the reform process there should be, say, privatisation of state enterprises, and in which order, or the lifting of capital controls or other trade barriers. Other economists dispute whether there is a right sequence.

SERVICES

Products of economic activity that you can’t drop on your foot, ranging from hairdressing to websites. In most countries, the share of economic activity accounted for by services rose steadily during the 20th century at the expense of AGRICULTURE and MANUFACTURING. More than two-thirds of OUTPUT in OECD countries, and up to four-fifths of employment, is now in the services sector.

SHADOW PRICE

The true economic PRICE of an activity: the OPPORTUNITY COST. Shadow prices can be calculated for those goods and SERVICES that do not have a market price, perhaps because they are set by GOVERNMENT. Shadow pricing is often used in COST-BENEFIT ANALYSIS, where the whole purpose of the analysis is to capture all the variables involved in a decision, not merely those for which market prices exist.

SHAREHOLDER VALUE

Putting shareholders first; the notion that all business activity should aim to maximize the total value of a company’s shares. Some critics argue that concentrating on shareholder value will be harmful to a company’s other stakeholders, such as employees, suppliers and customers.

SHARES

Financial securities, each granting part ownership of a company. In return for risking their capital by giving it to the company’s management to develop the business, shareholders get the right to a slice of whatever is left of the firm’s revenue after it has met all its other obligations. This money is paid as a dividend, although most companies retain some of their residual revenue for investment purposes. Shareholders have voting rights, including the right to vote in the election of the company’s board of directors. Shares are also known as equities. They can be traded in the public financial markets or held as private equity.

SHARPE RATIO

A rough guide to whether the rewards from an investment justify the risk, invented by bill sharpe, a winner of the nobel prize for economics and co-creator of the capital asset pricing model. You simply divide the past return on the investment (less the risk-free rate) by its standard deviation, the simplest measure of risk. The higher the sharpe ratio is the better, that is, the greater is the return per unit of risk. However, as it is a backward-looking measure, based on what an investment has done in the past, the sharpe ratio does not guarantee similar performance in future.

SHOCK

An unexpected event that affects an economy

SHORT-TERMISM

Doing things that make you better off in the short-run but worse off in the end. After the bursting of the stock market bubble and the failure of Enron at the start of the 2000s, much like during the 1980s, accusations of short-termism were often made against the stock market-focused capitalism of the united states and the UK. During the bubble, it was claimed, investors had become too focused on short-term profits and changes in share prices, and failed to probe deeply enough into long-term performance. As a result, managers did things that made their profits look as good as possible in the short run, often to the detriment of their company's long-term health. Indeed, many firms engaged in misleading and even fraudulent accounting practices to inflate short-term profits. In the 1980s and early 1990s, the complaint took a slightly different form, and was arguably less convincing, namely that short-termism caused lower levels of investment by businesses than in countries where the stock market was less important, such as Germany and japan.

SHORTING

Selling a security, such as a share, that you do not currently own, in the expectation that its price will fall by the time the security has to be delivered to its new owner. If the price does fall, you can buy the security at the lower price, deliver it to whoever you sold it to and make a profit. The risk is that the price rises, leaving you with a loss.

SIGNALLING

A solution to one of the biggest sources of market failure: asymmetric information. Often the biggest problem facing sellers is how to convince buyers that what they are selling is as good as they say it is. This problem arises in situations where the qualities of the thing being sold cannot be observed easily by buyers, who thus fear that sellers may be conning them. In such situations, an answer may be for sellers to do something that shows they mean what they say about quality. This something is what economists call signaling.
Going to a leading university might be worth far more for what it signals to prospective employers about your abilities than for what you learn as a student. Likewise, the fact that a firm is willing to spend a lot of money advertising its product may say far more about what it thinks of the product than any information included in the actual ad. To be useful, signals must impose more costs on those who use them to send false messages than any gains to be had from lying.

SIMPLE INTEREST

Interest calculated only on the initial amount borrowed or invested. Contrast with compound interest.

ADAM SMITH

The founder of economics as we know it. Born in Kirkland, fife, Adam Smith (1723–90) was educated at Glasgow and oxford, and in 1751 became professor of logic at Glasgow university. Eight years later he made his name by publishing the theory of moral sentiments. His 1776 book, an inquiry into the nature and causes of the wealth of nations, is the bible of classical economics. He emphasized the role of specialization (the division of labor), technical progress and capital investment as the main engines of economic growth. Above all, he stressed the importance of the invisible hand, the way in which self-interest pursued in free markets leads to the most efficient use of economic resources and makes everybody better off in the process.

SOCIAL BENEFITS/COSTS

The overall impact of an economic activity on the welfare of society. Social benefits/costs are the sum of private benefits/costs arising from the activity and any externalities.

SOCIAL CAPITAL

The amount of community spirit or trust that an economy has gluing it together. The more social capital there is, the more productive the economy will be. Yet, curiously, one of the best-known books to address the role of social capital, "bowling alone", by Robert Putnam of Harvard university, pointed out that Americans were far less likely to be members of community organizations, clubs or associations in the 1990s than they were in the 1950s. He illustrated his thesis by charting the decline of bowling leagues. Yet the American economy has gone from strength to strength. This has led some economists to question whether social capital is really as important as the theory suggests, and others to argue that membership of bowling leagues and other community organizations is simply not a good indicator of the amount of social capital in a

SOCIAL MARKET

The name given to the economic arrangements devised in Germany after the second world war. This blended market capitalism, strong labor protection and union influence, and a generous welfare state. The phrase has also been used to describe attempts to make capitalism more caring, and to the use of market mechanisms to increase the efficiency of the social functions of the state, such as the education system or prisons. More broadly, it refers to the study of the different social institutions underpinning every market economy.

SOCIALISM

The exact meaning of socialism is much debated, but in theory it includes some collective ownership of the means of production and a strong emphasis on equality, of some sort.

SOFT CURRENCY

A currency that is expected to drop in value relative to other currencies.

SOFT DOLLARS

The value of research services that brokerage companies provide “free” to INVESTMENT managers in exchange for the investment managers’ business. Economists disagree on whether or not such hidden payments are economically inefficient.

SOFT LOAN

A loan provided at below the market interest rate. Soft loans are used by international agencies to encourage economic activity in developing countries and to support non-commercial activities.

SOVEREIGN RISK

The risk that a government will default on its debt or on a loan guaranteed by it.

SPECULATION

An attitude to investment that is often criticized. According to critics, speculation involves buying or selling a financial asset with the aim of making a quick profit. This is contrasted with long-term investment, in which an asset is retained despite short-term fluctuations in its value. Speculators actually play a valuable role in financial markets as their appetite for frequent buying and selling provides liquidity to the markets. This benefits longer-term investors, too, as it enables them to get a good price when they do eventually sell.

SPOT PRICE

The price quoted for a transaction that is to be made on the spot, that is, paid for now for delivery now. Contrast spot markets with forward contracts and futures markets, where payment and/or delivery will be made at some future date. Also contrast with long-term contracts, in which a price is agreed for repeated transactions over an extended time period and which may not involve immediate payment in full.

SPREAD

The difference between one item and another. A much used term in financial markets. Examples are the differences between:
• the bid (what a dealer will pay) and ask or offer (what a dealer will sell for) price of a share or other security;
• the price an underwriter pays for an issue of bonds from a company and the price the underwriter charges the public;
• the yield on two different bonds.

STABILISATION

Government policies intended to smooth the economic cycle, expanding demand when unemployment is high and reducing it when inflation threatens to increase. Doing this by fine tuning has mostly proved harder than Keynesian policymakers expected, and it has become unfashionable. However, the use of automatic stabilizers remains widespread. For instance, social handouts from the state usually increase during tough times, and taxes increase (fiscal drag), boosting government revenue, when the economy is growing.

STABILITY AND GROWTH PACT

Budgetary rules agreed to by euro zone countries as a condition of joining the euro. The pact stipulates that all the countries will run a balanced budget in normal times. A government that runs a fiscal deficit bigger than 3% of GDP must take swift corrective action. And if any country breaches the 3% limit for more than three years in a row, it becomes liable to fines of billions of euros. The pact was supposed to be a powerful political symbol that euro-using countries would not cheat each other. However, Portugal became the first country to break the deficit limit by notching up 4.1% in 2001. When, in 2002, France and Germany also exceeded the 3% limit, some eu members were outraged and others lobbied for the pact to be modified or even scrapped.

STAGFLATION

Term coined in the 1970s for the twin economic problems of STAGNATION and rising INFLATION. Until then, these two economic blights had not appeared simultaneously. Indeed, policymakers believed the message of the PHILLIPS CURVE: that UNEMPLOYMENT and inflation were alternatives.

STAGNATION

A siprolonged recession, but not as severe as a depreson.

STAKEHOLDERS

All the parties that have an interest, financial or otherwise, in a company, including shareholders, creditors, bondholders, employees, customers, management, the community and government. How these different interests should be catered for, and what to do when they conflict, is much debated. In particular, there is growing disagreement between those who argue that companies should be run primarily in the interests of their shareholders, in order to maximize shareholder value, and those who argue that the wishes of shareholders should sometimes be traded off against those of other stakeholders.

STANDARD ERROR

A measure of the possible error in a statistical estimate.

STERILISED INTERVENTION

When a government or central bank buys or sells some of its reserves of foreign currency this can affect the country’s money supply. Selling reserves decreases the supply of the domestic currency; buying reserves increases the domestic money supply. Governments or central banks can sterilise (that is, cancel out) this effect of foreign exchange intervention on the money supply by buying or selling an equivalent amount of securities. For example, if the government increases reserves by buying foreign currency the domestic money supply will increase, unless it sells securities such as treasury bills to mop up the extra demand.

STOCHASTIC PROCESS

A process that exhibits random behavior. For instance, Brownian motion, which is often used to describe changes in share prices in an efficient market (the random walk), is a stochastic process.

STOCKS

Another term for shares. What are called ordinary shares in the UK are known as common stock in the united states. It is also another word for inventories of goods held by a firm to meet future demand.

STRESS-TESTING

A process for exploring how a portfolio of assets and/or liabilities would fare in extreme adverse conditions. A useful tool in risk management.

STRUCTURAL ADJUSTMENT

A programmer of policies designed to change the structure of an economy. Usually, the term refers to adjustment towards a market economy, under a programe approved by the IMF and/or WORLD BANK, which often supply structural adjustment funds to ease the pain of transition. Such policies are much criticized in the developing world, sometimes with good reason.

STRUCTURAL UNEMPLOYMENT

The hardest sort of unemployment to cure because it is caused by the structure of an economy rather than by changes in the economic cycle. Contrast with cyclical unemployment, which can, in theory if not always in practice, be cut without sparking inflation by stimulating faster economic growth. Structural unemployment can be reduced only by changing the economic structures causing it, for instance, by removing rules that limit labour market flexibility.

SUBSIDY

Money paid, usually by government, to keep prices below what they would be in a free market, or to keep alive businesses that would otherwise go bust, or to make activities happen that otherwise would not take place. Subsidies can be a form of protectionism by making domestic goods and services artificially competitive against imports. By distorting markets, they can impose large economic costs.

SUBSTITUTE GOODS

Goods for which an increase (or fall) in demand for one leads to a fall (or increase) in demand for the other – coca-cola and Pepsi, perhaps.

SUBSTITUTION EFFECT

When the price of petrol falls people buy more of it. There are two reasons.

• the income effect: cheaper petrol means that real purchasing power rises, so consumers have more to spend on everything, including petrol.

• the substitution effect: petrol has become cheaper relative to everything else, so people switch some of their consumption out of goods that are now relatively more expensive and buy more petrol instead

SUNK COSTS

When what is done cannot be undone. Sunk costs are costs that have been incurred and cannot be reversed, for example, spending on advertising or researching a product idea. They can be a barrier to entry. If potential entrants would have to incur similar costs, which would not be recoverable if the entry failed, they may be scared off.

SUPPLY

One of the two words economists use most, along with demand. These are the twin driving forces of the market economy. Supply is the amount of a good or service available at any particular price. The law of supply is that, other things remaining the same, the quantity supplied will increase as the price increases. The actual amount supplied will be determined, ultimately, by what the market price is, which depends on the amount demanded as well as what suppliers are willing to produce. What suppliers are willing to supply depends on several things:

• the cost of the factors of production;

• technology;

• the price of other goods and services (which, if high enough, might tempt the supplier to switch production to those products); and

• the ability of the supplier accurately to forecast demand and plan production to make the most of the opportunity.

SUPPLY-SIDE POLICIES

Increasing economic growth by making markets work more efficiently. In the 1980s, Ronald Reagan and Margaret thatcher championed supply-side policies as they attacked keynesian demand management. Pumping up demand without making markets work better would simply lead to higher inflation; economic growth would increase only when markets were able to operate more freely. Thus they pursued policies of deregulation, liberalisation and privatisation and encouraged free trade. To reduce unemployment, they tried to increase the efficiency of the jobs market by cutting the rate of income tax and attacking legal and other impediments to labour market flexibility. The results of these programmers are much debated. In particular, the belief, apparently supported by the laffer curve, that cutting tax rates would increase tax revenue did not always stand up well to real-world testing. Even so, it is now recognized that supply-side reforms are a crucial element in an effective economic policy.

SUSTAINABLE GROWTH

A term much used by environmentalists, meaning economic growth that can continue in the long term without non-renewable resources being used up or pollution becoming intolerable. Mainstream economists use the term, too, to describe a rate of growth that an economy can sustain indefinitely without causing a rise in inflation.

SYSTEMATIC RISK

The risk that remains after diversification, also known as market risk or undiversifiable risk. It is systematic risk that determines the return earned on a well-diversified portfolio of assets

SYSTEMIC RISK

The RISK of damage being done to the health of the FINANCIAL SYSTEM as a whole. A constant concern of BANK regulators is that the collapse of a single bank could bring down the entire financial system. This is why regulators often organize a rescue when a bank gets into financial difficulties. However, the expectation of such a rescue may create a MORAL HAZARD, encouraging banks to behave in ways that increase systemic risk. Another concern of regulators is that the ­RISK MANAGEMENT methods used by banks are so similar that they may increase systemic risk by creating a tendency for crowd behavior. In particular, problems in one market may cause banks in general to liquidate positions in other markets, causing a vicious cycle of LIQUIDITY being withdrawn from the financial system as everybody rushes for the emergency exit at once.

TANGIBLE ASSETS

Assets you can touch: buildings, machinery, gold, works of art, and so on. Contrast with intangible assets.

TARIFF

Often used to describe a tax on goods produced abroad imposed by the government of the country to which they are exported. Many countries have reduced such tariffs as part of the process of freeing up world trade.

TAX ARBITRAGE

Creating financial instruments or transactions that allow the parties involved to exploit loopholes in or differences between their tax exposures, so that all involved pay less tax.

TAX AVOIDANCE

Doing everything possible within the law to reduce your tax bill. Learned hand, an American Judge, once said: “there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible … nobody owes any public duty to pay more than the law demands.” Contrast with tax evasion.

TAX BASE

The thing or amount to which a tax rate applies. To collect income tax, for example, you need a meaningful definition of income. Definitions of the tax base can vary enormously, over time and among countries, especially when tax breaks are taken into account. As a result, a country with a comparatively high tax rate may not have a high tax burden if it has a more narrowly defined tax base than other countries. In recent years, the political unpopularity of high tax rates has lead many governments to lower rates and at the same time broaden the tax base, often leaving the tax burden unchanged.

TAX BURDEN

Total tax paid in a period as a proportion of total income in that period. It can refer to personal, corporate or national income.

TAX COMPETITION

Low-tax policies pursued by some countries in the hope of attracting international businesses and capital. Economists usually favour competition in any form. But some say that tax competition is often a beggar-thy-neighbor policy, which can reduce another country’s tax base, or force it to change its mix of taxes, or stop it taxing in the way it would like.

Economists who favour tax competition often cite a 1956 article by Charles Tiebout (1924–68) entitled "a pure theory of local expenditures". In it he argued that, faced with a choice of different combinations of tax and government services, taxpayers will choose to locate where they get closest to the mixture they want. Variations in tax rates among different countries are good, because they give taxpayers more choice and thus more chance of being satisfied. This also puts pressure on governments to be efficient. Thus measures to harmonise taxes are a bad idea.

There is at least one big caveat to this theory. Tiebout assumed, crucially, that taxpayers are highly mobile and able to move to wherever their preferred combination of taxes and benefits is on offer. But many taxpayers, including the great majority of workers, are not able to move easily. Tax competition may make it harder to redistribute from rich to poor through the tax system by allowing the rich to move to where taxes are not redistributive.