Loved and loathed; perhaps the most influential economist of his generation. He won the Nobel Prize for economics in 1976, one of many Chicago school economists to receive that honor. He has been recognized for his achievements in the study of consumption, monetary history and theory, and for demonstrating how complex policies aimed at economic stabilization can be.
A fierce advocate of free markets, Mr. Friedman argued for monetarism at a time when Keynesian policies were dominant. Unusually, his work is readily accessible to the layman. He argues that the problems of inflation and short-run unemployment would be solved if the Federal Reserve had to increase the money supply at a constant rate.
Like Adam Smith and Friedrich Hayek, who inspired him, Mr. Friedman praises the free market not just for its economic efficiency but also for its moral strength. For him, freedom--economic, political and civil--is an end in itself, not a means to an end. It is what makes life worthwhile. He has said he would prefer to live in a free country, even if it did not provide a higher standard of living, than a country run by an alternative regime. However, the likelihood of a free country being poorer than an unfree one strikes him as implausible; the economic as well as the moral superiority of free markets is, he has declared, "now proven".
An adviser to Richard Nixon, he was disappointed when the president went against the spirit of monetarism in 1971 by asking him to urge the chairman of the fed to increase the money supply more rapidly. The 1980s economic policies of Margaret Thatcher and general Pinochet were inspired--and defended--by Mr. Friedman. However, in 2003, he admitted that one of those policies, the targeting of the money supply, had "not been a success" and that he doubted he would "as of today push it as hard as i once did".
Saturday, January 30, 2010
Full employment
Jobs for all that want them. This does not mean zero unemployment because at any point in time some people do not want to work. Also, because some people are always between jobs, there will usually be some frictional unemployment. Full employment means that everyone who wants work and is willing to work at the market wage is in work. Most governments aim to achieve full employment, although nowadays they rarely try to lower unemployment below the nairu: the lowest jobless rate consistent with stable, low inflation.
Fungible
You can't tell them apart. Something is fungible when any one single specimen is indistinguishable from any other. Somebody who is owed $1 does not care which particular dollar he gets. Anything that people want to use as money must be fungible, whether it be gold bars, beads or shells.
General equilibrium
Economic perfection. This is when demand and supply are in balance (the market is in equilibrium) for each and every good and service in the economy. Nobody thinks that real-world economies can ever be that perfect; at best there is "partial equilibrium". But most economists think that general equilibrium is something worth aspiring to.
Generational accounting
A relatively new way of analyzing fiscal policy by identifying the financial costs and benefits of government policies to people of different ages, now living or yet to be born. Fiscal policy can distribute resources between different generations, sometimes deliberately and often inadvertently. At any moment in time, one generation may be in work and paying taxes that support other generations (those at school or retired) that are not working. Over its lifetime, one generation's mix of taxes paid and benefits received may differ sharply from that of another generation. Politicians are often tempted to ignore the needs of future generations (who, clearly, cannot vote at the time) in order to win the support of current generations, for instance by borrowing heavily to fund current spending. More fundamentally, because it incorporates all the tax and spending, current and future, to which a government is committed, generational accounting is a much better guide to whether fiscal policy is sustainable than measures such as the budget deficit, which looks only at taxes and spending in the current year.
Agricultural policy
Countries often provide support for their farmers using trade barriers and subsidy because, for example:
• domestic agriculture, even if it is inefficient by world standards, can be an insurance policy in case it becomes difficult (as it does, for example, in wartime) to buy agricultural produce from abroad;
• farmers groups have proved adept at lobbying;
• politicians have sought to slow the depopulation of rural areas;
• agricultural prices can be volatile, as a result of unpredictable weather, among other things; and
• financial support can provide a safety net in unexpectedly severe market conditions.
Broadly speaking, governments have tried two methods of subsidizing agriculture. The first, used in the United States during the 1930s and in the UK before it joined the European Union, is to top up farmers' incomes if they fall below a level deemed acceptable. Farmers may be required to set aside some of their land in return for this support. The second is to guarantee a minimum level of farm prices by buying up surplus supply and storing or destroying it if prices would otherwise fall below the guaranteed levels. This was the approach adopted by the EU when it set up its common agricultural policy. To keep down the direct cost of this subsidy the EU used trade barriers, including import levies, to minimize competition to EU farmers from produce available more cheaply on world agriculture markets. Recent American farm-support policy has combined income top-ups and some guaranteed prices.
As most governments have become more committed to international trade, such agricultural policies have come under increasing attack, although the free trade rhetoric has often run far ahead of genuine reform. In 2003, rich countries together spent over $300 billion a year supporting their farmers, more than six times what they spent on foreign aid. Finding a way to end agricultural support had become by far the biggest remaining challenge for those trying to negotiate global free trade.
• domestic agriculture, even if it is inefficient by world standards, can be an insurance policy in case it becomes difficult (as it does, for example, in wartime) to buy agricultural produce from abroad;
• farmers groups have proved adept at lobbying;
• politicians have sought to slow the depopulation of rural areas;
• agricultural prices can be volatile, as a result of unpredictable weather, among other things; and
• financial support can provide a safety net in unexpectedly severe market conditions.
Broadly speaking, governments have tried two methods of subsidizing agriculture. The first, used in the United States during the 1930s and in the UK before it joined the European Union, is to top up farmers' incomes if they fall below a level deemed acceptable. Farmers may be required to set aside some of their land in return for this support. The second is to guarantee a minimum level of farm prices by buying up surplus supply and storing or destroying it if prices would otherwise fall below the guaranteed levels. This was the approach adopted by the EU when it set up its common agricultural policy. To keep down the direct cost of this subsidy the EU used trade barriers, including import levies, to minimize competition to EU farmers from produce available more cheaply on world agriculture markets. Recent American farm-support policy has combined income top-ups and some guaranteed prices.
As most governments have become more committed to international trade, such agricultural policies have come under increasing attack, although the free trade rhetoric has often run far ahead of genuine reform. In 2003, rich countries together spent over $300 billion a year supporting their farmers, more than six times what they spent on foreign aid. Finding a way to end agricultural support had become by far the biggest remaining challenge for those trying to negotiate global free trade.
Adverse selection
When you do business with people you would be better off avoiding. This is one of two main sorts of market failure often associated with insurance. The other is moral hazard. Adverse selection can be a problem when there is asymmetric information between the seller of insurance and the buyer; in particular, insurance will often not be profitable when buyers have better information about their risk of claiming than does the seller. Ideally, insurance premiums should be set according to the risk of a randomly selected person in the insured slice of the population (55-year-old male smokers, say). In practice, this means the average risk of that group. When there is adverse selection, people who know they have a higher risk of claiming than the average of the group will buy the insurance, whereas those who have a below-average risk may decide it is too expensive to be worth buying. In this case, premiums set according to the average risk will not be sufficient to cover the claims that eventually arise, because among the people who have bought the policy more will have above-average risk than below-average risk. Putting up the premium will not solve this problem, for as the premium rises the insurance policy will become unattractive to more of the people who know they have a lower risk of claiming. One way to reduce adverse selection is to make the purchase of insurance compulsory, so that those for whom insurance priced for average risk is unattractive are not able to opt out.
Friday, January 29, 2010
Giffen goods
Named after Robert Giffen (1837-1910), a good for which demand increases as its price rises. But such goods may not exist in the real world.
Gini coefficient
An inequality indicator. The gini coefficient measures the inequality of income distribution within a country. It varies from zero, which indicates perfect equality, with every household earning exactly the same, to one, which implies absolute inequality, with a single household earning a country's entire income. Latin America is the world's most unequal region, with a gini coefficient of around 0.5; in rich countries the figure is closer to 0.3.
GNP
Short for gross national product, another measure of a country's economic performance. It is calculated by adding to GDP the income earned by residents from investments abroad, less the corresponding income sent home by foreigners who are living in the country.
Gresham's law
Bad money drives out good. One of the oldest laws in economics, named after Sir Thomas Gresham, an adviser to queen Elizabeth i of England. He observed that when a currency has been debased and a new one is introduced to replace it, the new one will be hoarded and effectively taken out of circulation, while the old one will continue to be used for transactions, to be got rid of as fast as possible.
Hawala
An ancient system of moving money based on trust. It predates western bank practices. Although it is now more associated with the Middle East, a version of hawala existed in china in the second half of the tang dynasty (618-907), known as fei qian, or flying money. In hawala, no money moves physically between locations; nowadays it is transferred by means of a telephone call or fax between dealers in different countries. No legal contracts are involved, and recipients are given only a code number or simple token, such as a low-value banknote torn in half, to prove that money is due. Over time, transactions in opposite directions cancel each other out, so physical movement is minimized. Trust is the only capital that the dealers have. With it, the users of hawala have a worldwide money-transmission service that is cheap, fast and free of bureaucracy.
From a government's point of view, however, informal money networks are threatening, since they lie outside official channels that are regulated and taxed. They fear they are used by criminals, including terrorists. Although this is probably true, by far the main users of hawala networks are overseas workers, who do not trust official money transfer methods or cannot afford them, remitting earnings to their families.
From a government's point of view, however, informal money networks are threatening, since they lie outside official channels that are regulated and taxed. They fear they are used by criminals, including terrorists. Although this is probably true, by far the main users of hawala networks are overseas workers, who do not trust official money transfer methods or cannot afford them, remitting earnings to their families.
Hayek, Friedrich
An influential economist of the Austrian school, who won the Nobel Prize for economics in 1974 for his theory of the business cycle many years after this body of work seemed to have been disproved by Keynes. Born in 1899, Hayek attended his home-town university of Vienna after the First World War. He was attracted to socialism until he read a pioneering Austrian economist, Ludwig Von Mises, on the subject, after which, he said, “the world was never the same again”.
Hayek argued that the business cycle originated from expanded credit creation by banks, which was followed by firms and people making mistaken capital investments in producing things for which the market turns out to be smaller (or larger) than expected. But after an initially enthusiastic reception, the Austrian business-cycle theory lost out in policy debates to Keynes’s general theory. After the Second World War, Hayek was a leading member of the Chicago school along with Milton Friedman, among others.
Hayek was a noted proponent of the free-market system and a critic of state planning. His 1944 book, the road to serfdom, anticipated the demise of command economies that sought to suppress price signals. This prediction came from his belief in the limits of human reason and has faith in the superior ability of capitalism to make efficient use of limited information and to learn by trial and error. His views, which echo Adam Smith’s invisible hand, are said to have inspired the free-market economic reforms undertaken in the 1980s by Margaret Thatcher and Ronald Reagan. He died in 1992.
Hayek argued that the business cycle originated from expanded credit creation by banks, which was followed by firms and people making mistaken capital investments in producing things for which the market turns out to be smaller (or larger) than expected. But after an initially enthusiastic reception, the Austrian business-cycle theory lost out in policy debates to Keynes’s general theory. After the Second World War, Hayek was a leading member of the Chicago school along with Milton Friedman, among others.
Hayek was a noted proponent of the free-market system and a critic of state planning. His 1944 book, the road to serfdom, anticipated the demise of command economies that sought to suppress price signals. This prediction came from his belief in the limits of human reason and has faith in the superior ability of capitalism to make efficient use of limited information and to learn by trial and error. His views, which echo Adam Smith’s invisible hand, are said to have inspired the free-market economic reforms undertaken in the 1980s by Margaret Thatcher and Ronald Reagan. He died in 1992.
Hedge funds
These bogey-men of the financial markets are often blamed, usually unfairly, when things go wrong. There is no simple definition of a hedge fund (few of them actually hedge). But they all aim to maximize their absolute returns rather than relative ones; that is, they concentrate on making as much money as possible, not (like many mutual funds) simply on outperforming an index. Although they are often accused of disrupting financial markets by their speculation, their willingness to bet against the herd of other investors may push security prices closer to their true fundamental values, not away.
Horizontal equity
One way to keep taxation fair. Horizontal equity means that people with a similar ability to pay taxes should pay the same amount.
Horizontal integration
Merging with another firm just like yours, for example, two biscuit makers becoming one. Contrast with vertical integration, which is merging with a firm at a different stage in the supply chain. Horizontal integration often raises antitrust concerns, as the combined firm will have a larger market share than either firm did before merging.
Hot money
Money that is held in one currency but is liable to switch to another currency at a moment’s notice in search of the highest available returns, thereby causing the first currency’s exchange rate to plummet. It is often used to describe the money invested in currency markets by speculators.
Human development index
The “good life” guide. Calculated since 1990 by the United Nations development programme, the human development index quantifies a country’s development in terms of such things as education, length of life and clean water, as well as income. Since the mid-1970s, the quality of life for humans throughout the world has improved enormously overall. America's human development index rose by around one-tenth between 1975 and 2001, for example. More spectacularly, during the same period, china's rose by around 40% and Indonesia’s by nearly 50%. Even so, in 2001, some 54 countries were poorer than in 1990, and in 34, mostly in Africa and the former Soviet Union, life expectancy had fallen, reversing an impressive long-term trend, largely because of the HIV/AIDS epidemic and crime. Some 21 countries had a lower overall human development index in 2003 than in 1990.
Hypothecation
Earmarking taxes for a specific purpose. It may be a clever way to get around public hostility to paying more in taxation. If people are told that a specific share of their income tax will go to some popular cause, say education or health, they may be more willing to cough up. At the very least they may be forced to make more informed decisions about the trade-offs between taxes and public services. There is a downside, however. Hypothecated taxes may tie the hands of a government at times when the hypothecated revenue could be spent to better effect elsewhere in the public sector. Conversely, and perhaps more likely, hypothecated taxes may prove to be less hypothecated than the public is led to believe. Civil servants, doubtless under pressure from their political bosses, can usually find ways to fudge the definition of the specific purpose for which a tax is hypothecated, letting government regain control over how the money is spent.
Hysteresis
Lagging; slow to respond. Traditionally, economists believed that high unemployment was a -cyclical phenomenon. Eventually, unemployment would cause people to lower their wage demands, and so new job opportunities would arise and unemployment would fall. More recently, however, economists have suggested that some unemployed people, especially the long-term jobless, can display hysteresis. They find it hard, perhaps impossible, to return to work, even when jobs become available. For instance, unemployed workers may gradually lose the motivation, self-confidence or the self-discipline, needed to get to the workplace and fulfill job requirements. Or their skills may become outdated and redundant. State benefits for the jobless may contribute to this hysteresis by making it easier from them to stay out of work.
ILO
Short for international labor organization, founded in 1919 as part of the treaty of Versailles, which created the League of Nations. In 1946, it became the first specialized agency of the UN. Based in Geneva, it formulates international labor standards, setting out desired minimum rights for workers: freedom of association; the right to organize and engage in collective bargaining; equality of opportunity and treatment; and the abolition of forced labor. It also compiles international labor statistics. One reason for its formation was the hope that international labor standards would stop countries using lower standards to gain a competitive advantage. From the 1980s onwards, the ILO approach came under attack as attention turned to the costs of high labor standards, notably slower economic growth. Universal minimum labor standards might also work against free trade. Imposing rich-country labor standards on poorer countries might help keep the rich rich and the poor poor.
Income
The flow of money to the factors of production: wages to labour; profit to enterprise and capital; interest also to capital; rent to land. Wages left for spending after paying taxes is known as disposable income. For countries, see national income.
Income effect
A change in the demand for a good or service caused by a change in the income of consumers rather than, say, a change in consumer tastes. Contrast with substitution effect.
Incumbent advantage
The importance of being there already. Firms that are in a market can have a significant competitive advantage over aspiring entrants to that market, for instance, through having the opportunity to erect barriers to entry.
Indexation
Keeping pace with inflation. In many countries, wages, pensions, unemployment benefits and some other sorts of income are automatically raised according to recent movements in the consumer price index. This allows these different sorts of income to retain their value in real terms.
Indifference curve
A curve that joins together different combinations of goods and services that would each give the consumer the same amount of satisfaction (utility). In other words, consumers are indifferent to which of the combinations they get.
Inelastic
When the supply or demand for something is insensitive to changes in another variable, such as price.
Inferior goods
Products that are less in demand as consumers get richer. For normal goods, demand increases as consumers have more to spend.
Infrastructure
The economic arteries and veins. Roads, ports, railways, airports, power lines, pipes and wires that enable people, goods, commodities, water, energy and information to move about efficiently. Increasingly, infrastructure is regarded as a crucial source of economic competitiveness. Investment in infrastructure can yield unusually high returns because it increases people’s choices: of where to live and work, what to consume, what sort of economic activities to carry out, and of other people to communicate with. Some parts of a country’s infrastructure may be a natural monopoly, such as water pipes. Others, such as traffic lights, may be public goods. Some may have a network effect, such as telephone cables. Each of these factors has encouraged government provision of infra¬structure, often with the familiar downsides of state intervention: bad planning, inefficient delivery and corruption.
Institutional investors
The big hitters of the financial markets: pension funds, fund-management companies, insurance companies, investment banks, hedge funds, charitable endowment trusts. In the United States, around half of publicly traded shares are owned by institutions and half by individual investors. In the UK, institutions own over two-thirds of listed shares. This gives them considerable clout, including the ability to move the prices in financial markets and to call company bosses to account. But because institutions mostly invest other people’s money, they are themselves prone to agency costs, sometimes acting against the best long-term interests of the people who trust them with their savings.
Intangible assets
Valuable things, even though you cannot drop them on your foot – an idea, say, especially one protected by a patent; an effective corporate culture; human capital; a popular brand. Contrast with tangible assets.
Intellectual capital
The part of a country's or a firm’s capital or an individual’s human capital that consists of ideas rather than something more physical. It can often be protected through patents or other intellectual property laws.
Intervention
When central banks try to influence an exchange rate by buying the currency they want to appreciate and selling the one they want to weaken. The evidence seems to suggest that it is at best a short-term measure. In the longer term, governments probably do not have the resources to beat market forces.
Job search
The time taken to find a new job. Because some people will devote all their time to this search, there will always be some frictional unemployment, even when there is otherwise full employment.
Joint supply
Some products or production processes have more than one use. For instance, cows can both provide milk and be eaten. If farmers increase the number of cows they own in response to an increase in demand for milk, they are also likely to increase, a little later, the supply of meat, causing beef prices to fall.
Kleptocracy
Corrupt, thieving government, in which the politicians and bureaucrats in charge use the powers of the state to feather their own nests. Russia in the years immediately after the fall of communism was a clear-cut example, with mafia-friendly government members allocating themselves valuable shares during the privatization of state-owned companies, accepting bribes from foreign businesses, not collecting taxes from “helpful” companies and siphoning off international aid into their personal offshore bank accounts.
Kondratieff wave
A 50 year-long business cycle, named after Nicolai Kondratieff, a Russian economist. He claimed to have identified cycles of economic activity lasting half a century or more in his 1925 book, the long waves in economic life. Because this implied that capitalism was, ultimately, a stable system, in contrast to the Marxist view that it was self-destructively unstable, he ended up in one of Stalin’s prisons, where he died. Alas, there is little hard evidence to support Kondratieff’s conclusion.
Labour intensive
A production process that involves comparatively large amounts of labor; the opposite of capital intensive.
Labor market flexibility
A flexible labor market is one in which it is easy and inexpensive for firms to vary the amount of labor they use, including by changing the hours worked by each employee and by changing the number of employees. This often means minimal regulation of the terms of employment (no minimum wage, say) and weak (or no) trade unions. Such flexibility is characterised by its opponents as giving firms all the power, allowing them to fire employees at a moment’s notice and leaving workers feeling insecure.
Opponents of labor market flexibility claim that labor laws that make workers feel more secure encourage employees to invest in acquiring skills that enable them to do their current job better but that could not be taken with them to another firm if they were let go. Supporters claim that it improves economic efficiency by leaving it to market forces to decide the terms of employment. Broadly speaking, the evidence is that greater flexibility is associated with lower rates of unemployment and higher GDP per head.
Opponents of labor market flexibility claim that labor laws that make workers feel more secure encourage employees to invest in acquiring skills that enable them to do their current job better but that could not be taken with them to another firm if they were let go. Supporters claim that it improves economic efficiency by leaving it to market forces to decide the terms of employment. Broadly speaking, the evidence is that greater flexibility is associated with lower rates of unemployment and higher GDP per head.
Labor theory of value
The notion that the value of any good or service depends on how much labor it uses up. First suggested by Adam Smith, it took a central place in the philosophy of Karl Marx. Some Neo-Classical economists disagreed with this theory, arguing that the price of something was independent of how much labor went into producing it and was instead determined solely by supply and demand.
Laffer curve
Legend has it that in November 1974 Arthur Laffer, a young economist, drew a curve on a napkin in a Washington bar, linking average tax rates to total tax revenue. Initially, higher tax rates would increase revenue, but at some point further increases in tax rates would cause revenue to fall, for instance by discouraging people from working. The curve became an icon of supply-side economics. Some economists said that it proved that most governments could raise more revenue by cutting tax rates, an argument that was often cited in the 1980s by the tax-cutting governments of Ronald Reagan and Margaret Thatcher. Other economists reckoned that most countries were still at a point on the curve at which raising tax rates would increase revenue. The lack of empirical evidence meant that nobody could really be sure where the United States and other countries were on the Laffer curve. However, after the Reagan administration cut tax rates revenue fell at first. American tax rates were already low compared with some countries, especially in continental Europe, and it remains possible that these countries are at a point on the Laffer curve where cutting tax rates would pay.
Lagging indicators
Old news. Some economic statistics move weeks or months after changes in the business cycle or inflation. They may not be a reliable guide to the current state of an economy or its future path. Contrast with leading indicators.
Laissez-faire
Let-it-be economics: the belief that an economy functions best when there is no interference by government. It can be traced to the 18th-century French Physiocrats, who believed in government according to the natural order and opposed mercantilism. Adam smith and others turned it into a central tenet of classical economics, as it allowed the invisible hand to operate efficiently. (But even they saw a need for some limited government role in the economy.) In the 19th century, it inspired the British political movement that secured the repeal of the Corn Laws and promoted free trade, and gave birth to the economist in 1843. In the 20th century, laissez-faire was often seen as synonymous with supporting monopoly and allowing the business cycle to boom and bust, and it came off second best against Keynesian policies of interventionist government. However, mounting evidence of the inefficiency of state intervention inspired the free market policies of Ronald Reagan and Margaret Thatcher in the 1980s, both of whom stressed the importance of laissez-faire.
Business cycle
Boom and bust. The long-run pattern of economic growth and recession. According to the centre for international business cycle research at Columbia university, between 1854 and 1945 the average expansion lasted 29 months and the average contraction 21 months. Since the Second World War, however, expansions have lasted almost twice as long, an average of 50 months, and contractions have shortened to an average of only 11 months. Over the years, economists have produced numerous theories of why economic activity fluctuates so much, none of them particularly convincing. A Kitchin cycle supposedly lasted 39 months and was due to fluctuations in companies' inventories. The Juglar cycle would last 8—9 years as a result of changes in investment in plant and machinery. Then there was the 20-year Kuznets cycle, allegedly driven by house-building, and, perhaps the best-known theory of them all, the 50-year kondratieff wave. Hayek tangled with Keynes over what caused the business cycle, and won the Nobel Prize for economics for his theory that variations in an economy's output depended on the sort of capital it had. Taking a quite different tack, in the late 1960s Arthur Okun, an economic adviser to presidents Kennedy and Johnson, proclaimed that the business cycle was "obsolete". A year later, the American economy was in recession. Again, in the late 1990s, some economists claimed that technological innovation and globalization meant that the business cycle was a thing of the past. Alas, they were soon proved wrong
Bretton woods
A conference held at Bretton woods, New Hampshire, in 1944, which designed the structure of the international monetary system after the second world war and set up the IMF and the world bank. It was agreed that the exchange rates of IMF members would be pegged to the dollar, with a maximum variation of 1% either side of the agreed rate. Rates could be adjusted more sharply only if a country's balance of payments was in fundamental disequilibrium. In august 1971 economic troubles and the cost of financing the Vietnam War led the American president, Richard Nixon, to devalue the dollar. This shattered confidence in the fixed exchange rate system and by 1973 all of the main currencies were floating freely, at rates set mostly by market forces rather than government fiat.
Big Mac index
The big Mac index was devised by Pam Woodall of the economist in 1986, as a light-hearted guide to whether currencies are at their "correct" level. It is based on one of the oldest concepts in international economics, Purchasing Power Parity (PPP), the notion that a dollar, say, should buy the same amount in all countries. In the long run, argue ppp fans, currencies should move towards the exchange rate, which equalizes the prices of an identical basket of goods and services in each country. In this case, the basket is a McDonalds’ big Mac, which is produced in more than 100 countries. The big Mac PPP is the exchange rate that would leave hamburgers costing the same in the United States as elsewhere. Comparing actual exchange rates with PPP signals whether a currency is undervalued or overvalued. Some studies have found that the big Mac index is often a better predictor of currency movements than more theoretically rigorous models.
Beta
Part of an economic theory for valuing financial securities and calculating the cost of capital, known as the capital asset pricing model, beta measures the sensitivity of the price of a particular asset to changes in the market as a whole. If a company's shares have a beta of 0.8 it implies that on average the share price will change by 0.8% if there is a 1% change in the market. There is a long-running debate about whether a beta calculated from a security's past relationship with the market actually predicts how that relationship will behave in future, leading some doubting economists to claim that beta is "dead".
Bank
Starting out as places that would guard your money, banks became the main source of credit creation. Increasingly, however, borrowers are turning to the financial markets and to non-savings institutions, such as credit-card companies and consumer-finance firms, when they need a loan. This is reducing the profitability of traditional bank lending and has led many banks to enter new areas of business, such as selling insurance policies and mutual funds. Increasingly, too, traditional banks are selling off parcels of their loans in the financial markets by a process called securitization.
What the most efficient split is between bank lending and other sorts of lending is debatable. Economists argue endlessly about whether an economy such as the united states, in which firms rely more heavily on the equity and debt markets than on banks to fund their investment, is better than one such as, say, Germany, in which banks have traditionally been the main source of corporate finance.
Banks come in many different forms. Commercial banks, also known as retail banks, cater directly for the general public and lend to (mostly small and medium-sized) firms. In the past, they did so largely through a network of bank branches, although increasingly these are giving way to ATM machines, the telephone and the internet. Wholesale banks largely transact with other banks and financial institutions. Investment banks, also known as merchant banks, concentrate on raising money for companies from private investors or in the financial markets, by finding buyers for their equity and corporate bonds. Universal banks do most or all of the above including, through bancassurance, selling insurance. These banks have long been a feature of continental European economies. However, in the United States financial laws such as the glass-steagall act have separated different forms of banking from each other and kept banks out of the insurance business. These laws were abolished in 1999, although during the preceding couple of decades regulators effectively dismantled them by changing the way they were applied. Even so, because of these and other laws, which for many years stopped banks from operating across state borders, the United States has far more lending institutions than other countries. In 2003 there were over four lending institutions per 100,000 people in the United States, compared with fewer than one per 100,000 in the UK and France.
What the most efficient split is between bank lending and other sorts of lending is debatable. Economists argue endlessly about whether an economy such as the united states, in which firms rely more heavily on the equity and debt markets than on banks to fund their investment, is better than one such as, say, Germany, in which banks have traditionally been the main source of corporate finance.
Banks come in many different forms. Commercial banks, also known as retail banks, cater directly for the general public and lend to (mostly small and medium-sized) firms. In the past, they did so largely through a network of bank branches, although increasingly these are giving way to ATM machines, the telephone and the internet. Wholesale banks largely transact with other banks and financial institutions. Investment banks, also known as merchant banks, concentrate on raising money for companies from private investors or in the financial markets, by finding buyers for their equity and corporate bonds. Universal banks do most or all of the above including, through bancassurance, selling insurance. These banks have long been a feature of continental European economies. However, in the United States financial laws such as the glass-steagall act have separated different forms of banking from each other and kept banks out of the insurance business. These laws were abolished in 1999, although during the preceding couple of decades regulators effectively dismantled them by changing the way they were applied. Even so, because of these and other laws, which for many years stopped banks from operating across state borders, the United States has far more lending institutions than other countries. In 2003 there were over four lending institutions per 100,000 people in the United States, compared with fewer than one per 100,000 in the UK and France.
Balance of payments
The total of all the money coming into a country from abroad less all of the money going out of the country during the same period. This is usually broken down into the current account and the capital account. The current account includes:
• visible trade (known as merchandise trade in the united states), which is the value of exports and imports of physical goods;
• invisible trade, which is receipts and payments for services, such as banking or advertising, and other intangible goods, such as copyrights, as well as cross-border dividend and interest payments;
• private transfers, such as money sent home by expatriate workers;
• official transfers, such as international aid.
The capital account includes:
• long-term capital flows, such as money invested in foreign firms, and profits made by selling those investments and bringing the money home;
• short-term capital flows, such as money invested in foreign currencies by international speculators, and funds moved around the world for business purposes by multinational companies. These short-term flows can lead to sharp movements in exchange rates, which bear little relation to what currencies should be worth judging by fundamental measures of value such as purchasing power parity.
As bills must be paid, ultimately a country's accounts must balance (although because real life is never that neat a balancing item is usually inserted to cover up the inconsistencies).
"Balance of payments crisis" is a politically charged phrase. But a country can often sustain a current account deficit for many years without its economy suffering, because any deficit is likely to be tiny compared with the country's national income and wealth. Indeed, if the deficit is due to firms importing technology and other capital goods from abroad, which will improve their productivity, the economy may benefit. A deficit that has to be financed by the public sector may be more problematic, particularly if the public sector faces limits on how much it can raise taxes or borrow or has few financial reserves. For instance, when the Russian government failed to pay the interest on its foreign debt in august 1998 it found it impossible to borrow any more money in the international financial markets. Nor was it able to increase taxes in its collapsing economy or to find anybody within Russia willing to lend it money. That truly was a balance of payments crisis.
In the early years of the 21st century, economists started to worry that the United States would find itself in a balance of payments crisis. Its current account deficit grew to over 5% of its GDP, making its economy increasingly reliant on foreign credit.
• visible trade (known as merchandise trade in the united states), which is the value of exports and imports of physical goods;
• invisible trade, which is receipts and payments for services, such as banking or advertising, and other intangible goods, such as copyrights, as well as cross-border dividend and interest payments;
• private transfers, such as money sent home by expatriate workers;
• official transfers, such as international aid.
The capital account includes:
• long-term capital flows, such as money invested in foreign firms, and profits made by selling those investments and bringing the money home;
• short-term capital flows, such as money invested in foreign currencies by international speculators, and funds moved around the world for business purposes by multinational companies. These short-term flows can lead to sharp movements in exchange rates, which bear little relation to what currencies should be worth judging by fundamental measures of value such as purchasing power parity.
As bills must be paid, ultimately a country's accounts must balance (although because real life is never that neat a balancing item is usually inserted to cover up the inconsistencies).
"Balance of payments crisis" is a politically charged phrase. But a country can often sustain a current account deficit for many years without its economy suffering, because any deficit is likely to be tiny compared with the country's national income and wealth. Indeed, if the deficit is due to firms importing technology and other capital goods from abroad, which will improve their productivity, the economy may benefit. A deficit that has to be financed by the public sector may be more problematic, particularly if the public sector faces limits on how much it can raise taxes or borrow or has few financial reserves. For instance, when the Russian government failed to pay the interest on its foreign debt in august 1998 it found it impossible to borrow any more money in the international financial markets. Nor was it able to increase taxes in its collapsing economy or to find anybody within Russia willing to lend it money. That truly was a balance of payments crisis.
In the early years of the 21st century, economists started to worry that the United States would find itself in a balance of payments crisis. Its current account deficit grew to over 5% of its GDP, making its economy increasingly reliant on foreign credit.
Average
A number that is calculated to summarize a group of numbers. The most commonly used average is the mean, the sum of the numbers divided by however many numbers there are in the group. The median is the middle value in a group of numbers ranked in order of size. The mode is the number that occurs most often in a group of numbers. Take the following group of numbers: 1, 2, 2, 9, 12, 13, 17
The mean is 56/7=8
The median is 9
The mode is 2
The mean is 56/7=8
The median is 9
The mode is 2
Auctions
Going, going, gone. Holding an auction can be an extremely efficient way for a seller to set the price of its products, especially if it does not have much information about how much people may be willing to pay for them. Auctions fascinate economists, especially those who specialize in game theory. They have long been a feature of the sale of art and antiques in the rooms of firms such as Sotheby’s and Christie’s. But in recent years they have played a growing role in other parts of the economy, ranging from the allocation of government-controlled broadcasting bandwidth to the awarding of work to subcontractors by governments and big firms using competitive tendering, and even more recently the sale of goods over the internet.
An English auction is the most familiar. Bidders compete to offer higher prices and drop out until only one remains. In a Dutch auction, the auctioneer calls out a high price then keeps lowering it until there is a buyer. There are various forms of sealed bid auctions. In a first price sealed bid, each buyer submits a price in a sealed envelope and all bids are opened simultaneously, with the highest offer winning. In a second (or third, fourth, and so on) price sealed bid, the highest bidder wins but pays only the second (third, fourth) highest price bid.
An English or Dutch auction will work well for a seller if there is more than one serious bidder, as competition will ensure that the price is set at the level at which it is not worth more to any other bidder but the winner. Indeed, in a competitive auction the successful bidder may end up offering more than what is being auctioned is actually worth. This is known as the winner's curse.
Which method will generate the best price for the seller depends on how many bidders take part and how well informed they are. Unfortunately for the seller, this information is not always available before the auction takes place.
An English auction is the most familiar. Bidders compete to offer higher prices and drop out until only one remains. In a Dutch auction, the auctioneer calls out a high price then keeps lowering it until there is a buyer. There are various forms of sealed bid auctions. In a first price sealed bid, each buyer submits a price in a sealed envelope and all bids are opened simultaneously, with the highest offer winning. In a second (or third, fourth, and so on) price sealed bid, the highest bidder wins but pays only the second (third, fourth) highest price bid.
An English or Dutch auction will work well for a seller if there is more than one serious bidder, as competition will ensure that the price is set at the level at which it is not worth more to any other bidder but the winner. Indeed, in a competitive auction the successful bidder may end up offering more than what is being auctioned is actually worth. This is known as the winner's curse.
Which method will generate the best price for the seller depends on how many bidders take part and how well informed they are. Unfortunately for the seller, this information is not always available before the auction takes place.
Asian crisis
During 1997-98, many of the East Asian tiger economies suffered a severe financial and economic crisis. This had big consequences for the global financial markets, which had become increasingly exposed to the promise that Asia had seemed to offer. The crisis destroyed wealth on a massive scale and sent absolute poverty shooting up. In the banking system alone, corporate loans equivalent to around half of one year's gdp went bad - a destruction of savings on a scale more usually associated with a full-scale war. The precise cause of the crisis remains a matter of debate. Fingers have been pointed at the currency peg adopted by some countries, and a reduction of capital controls in the years before the crisis. Some blamed economic contagion. The crisis brought an end to a then widespread belief that there was a distinct "Asian way" of capitalism that might prove just as successful as capitalism in America or Europe. Instead, critics turned their fire on Asian cronyism, ill-disciplined banking and lack of transparency. In the years following the crisis, most of the countries involved have introduced reforms designed to increase transparency and improve the health of the banking system, although some (such as south Korea) went much further than others (such as Indonesia).
Antitrust
Government policy for dealing with monopoly. Antitrust laws aim to stop abuses of market power by big companies and, sometimes, to prevent corporate mergers and acquisitions that would create or strengthen a monopolist. There have been big differences in antitrust policies both among countries and within the same country over time. This has reflected different ideas about what constitutes a monopoly and, where there is one, what sorts of behaviour are abusive.
In the United States, monopoly policy has been built on the Sherman antitrust act of 1890. This prohibited contracts or conspiracies to restrain trade or, in the words of a later act, to monopolies commerce. In the early 20th century this law was used to reduce the economic power wielded by so-called "robber barons", such as JP Morgan and john d. Rockefeller, who dominated much of American industry through huge trusts that controlled companies' voting shares. Du Pont chemicals, the railroad companies and Rockefeller’s standard oil, among others, were broken up. In the 1970s the Sherman act was turned (ultimately without success) against IBM, and in 1982 it secured the break-up of AT&T'S nationwide telecoms monopoly.
In the 1980s a more laissez-faire approach was adopted, underpinned by economic theories from the Chicago school. These theories said that the only justification for antitrust intervention should be that a lack of competition harmed consumers, and not that a firm had become, in some ill-defined sense, too big. Some monopolistic activities previously targeted by antitrust authorities, such as predatory pricing and exclusive marketing agreements, were much less harmful to consumers than had been thought in the past. They also criticized the traditional method of identifying a monopoly, which was based on looking at what percentage of a market was served by the biggest firm or firms, using a measure known as the Herfindahl-Hirschman index. Instead, they argued that even a market dominated by one firm need not be a matter of antitrust concern, provided it was a contestable market.
In the 1990s American antitrust policy became somewhat more interventionist. A high-profile lawsuit was launched against Microsoft in 1998. The giant software company was found guilty of anti-competitive behavior, which was said to slow the pace of innovation. However, fears that the firm would be broken up, signaling a far more intervention list American antitrust policy, proved misplaced. The firm was not severely punished.
In the UK, antitrust policy was long judged according to what policymakers decided was in the public interest. At times this approach was comparatively permissive of mergers and acquisitions; at others it was less so. However, in the mid-1980s the UK followed the American lead in basing antitrust policy on whether changes in competition harmed consumers. Within the rest of the European Union several big countries pursued policies of building up national champions, allowing chosen firms to enjoy some monopoly power at home which could be used to make them more effective competitors abroad. However, during the 1990s the European commission became increasingly active in antitrust policy, mostly seeking to promote competition within the EU.
In 2000, the EU controversially blocked a merger between two American firms, GE and Honeywell; the deal had already been approved by America's antitrust regulators. The controversy highlighted an important issue. As globalization increases, the relevant market for judging whether market power exists or is being abused will increasingly cover far more territory than any one single economy. Indeed, there may be a need to establish a global antitrust watchdog, perhaps under the auspices of the world trade organization.
In the United States, monopoly policy has been built on the Sherman antitrust act of 1890. This prohibited contracts or conspiracies to restrain trade or, in the words of a later act, to monopolies commerce. In the early 20th century this law was used to reduce the economic power wielded by so-called "robber barons", such as JP Morgan and john d. Rockefeller, who dominated much of American industry through huge trusts that controlled companies' voting shares. Du Pont chemicals, the railroad companies and Rockefeller’s standard oil, among others, were broken up. In the 1970s the Sherman act was turned (ultimately without success) against IBM, and in 1982 it secured the break-up of AT&T'S nationwide telecoms monopoly.
In the 1980s a more laissez-faire approach was adopted, underpinned by economic theories from the Chicago school. These theories said that the only justification for antitrust intervention should be that a lack of competition harmed consumers, and not that a firm had become, in some ill-defined sense, too big. Some monopolistic activities previously targeted by antitrust authorities, such as predatory pricing and exclusive marketing agreements, were much less harmful to consumers than had been thought in the past. They also criticized the traditional method of identifying a monopoly, which was based on looking at what percentage of a market was served by the biggest firm or firms, using a measure known as the Herfindahl-Hirschman index. Instead, they argued that even a market dominated by one firm need not be a matter of antitrust concern, provided it was a contestable market.
In the 1990s American antitrust policy became somewhat more interventionist. A high-profile lawsuit was launched against Microsoft in 1998. The giant software company was found guilty of anti-competitive behavior, which was said to slow the pace of innovation. However, fears that the firm would be broken up, signaling a far more intervention list American antitrust policy, proved misplaced. The firm was not severely punished.
In the UK, antitrust policy was long judged according to what policymakers decided was in the public interest. At times this approach was comparatively permissive of mergers and acquisitions; at others it was less so. However, in the mid-1980s the UK followed the American lead in basing antitrust policy on whether changes in competition harmed consumers. Within the rest of the European Union several big countries pursued policies of building up national champions, allowing chosen firms to enjoy some monopoly power at home which could be used to make them more effective competitors abroad. However, during the 1990s the European commission became increasingly active in antitrust policy, mostly seeking to promote competition within the EU.
In 2000, the EU controversially blocked a merger between two American firms, GE and Honeywell; the deal had already been approved by America's antitrust regulators. The controversy highlighted an important issue. As globalization increases, the relevant market for judging whether market power exists or is being abused will increasingly cover far more territory than any one single economy. Indeed, there may be a need to establish a global antitrust watchdog, perhaps under the auspices of the world trade organization.
Agency costs
These can arise when somebody (the principal) hires somebody else (the agent) to carry out a task and the interests of the agent conflict with the interests of the principal. An example of such principal-agent problems comes from the relationship between the shareholders who own a public company and the managers who run it. The owners would like managers to run the firm in ways that maximize the value of their shares, whereas the managers' priority may be, say, to build a business empire through rapid expansion and mergers and acquisitions, which may not increase their firm's share price.
One way to reduce agency costs is for the principal to monitor what the agent does to make sure it is what he has been hired to do. But this can be costly, too. It may be impossible to define the agent's job in a way that can be monitored effectively. For instance, it is hard to know whether a manager who has expanded a firm through an acquisition that reduced its share price was pursuing his own empire-building interests or, say, was trying to maximize shareholder value but was unlucky.
Another way to lower agency costs, especially when monitoring is too expensive or too difficult, is to make the interests of the agent more like those of the principal. For instance, an increasingly common solution to the agency costs arising from the separation of ownership and management of public companies is to pay managers partly with shares and share options in the company. This gives the managers a powerful incentive to act in the interests of the owners by maximizing shareholder value. But even this is not a perfect solution. Some managers with lots of share options have engaged in accounting fraud in order to increase the value of those options long enough for them to cash some of them in, but to the detriment of their firm and its other shareholders.
One way to reduce agency costs is for the principal to monitor what the agent does to make sure it is what he has been hired to do. But this can be costly, too. It may be impossible to define the agent's job in a way that can be monitored effectively. For instance, it is hard to know whether a manager who has expanded a firm through an acquisition that reduced its share price was pursuing his own empire-building interests or, say, was trying to maximize shareholder value but was unlucky.
Another way to lower agency costs, especially when monitoring is too expensive or too difficult, is to make the interests of the agent more like those of the principal. For instance, an increasingly common solution to the agency costs arising from the separation of ownership and management of public companies is to pay managers partly with shares and share options in the company. This gives the managers a powerful incentive to act in the interests of the owners by maximizing shareholder value. But even this is not a perfect solution. Some managers with lots of share options have engaged in accounting fraud in order to increase the value of those options long enough for them to cash some of them in, but to the detriment of their firm and its other shareholders.
Absolute advantage
This is the simplest yardstick of economic performance. If one person, firm or country can produce more of something with the same amount of effort and resources, they have an absolute advantage over other producers. Being the best at something does not mean that doing that thing is the best way to use your scarce economic resources. The question of what to specialize in--and how to maximize the benefits from international trade--is best decided according to comparative advantage. Both absolute and comparative advantage may change significantly over time.
Sunday, January 24, 2010
Advertising
Many firms advertise their goods or services, but are they wasting economic resources? Some economists reckon that advertising merely manipulates consumer tastes and creates desires that would not otherwise exist. By increasing product differentiation and encouraging brand loyalty advertising may make consumers less price sensitive, moving the market further from perfect competition towards imperfect competition (see monopolistic competition) and increasing the ability of firms to charge more than marginal cost. Heavy spending on advertising may also create a barrier to entry, as a firm entering the market would have to spend a lot on advertising too.
However, some economists argue that advertising is economically valuable because it increases the flow of information in the economy and reduces the asymmetric information between the seller and the consumer. This intensifies competition, as consumers can be made aware quickly when there is a better deal on offer.
However, some economists argue that advertising is economically valuable because it increases the flow of information in the economy and reduces the asymmetric information between the seller and the consumer. This intensifies competition, as consumers can be made aware quickly when there is a better deal on offer.
Comparative advantage
Paul Samuelsson, one of the 20th century’s greatest economists, once remarked that the principle of comparative advantage was the only big idea that economics had produced that was both true and surprising. It is also one of the oldest theories in economics, usually ascribed to David Ricardo. The theory underpins the economic case for free trade. But it is often misunderstood or misrepresented by opponents of free trade. It shows how countries can gain from trading with each other even if one of them is more efficient – it has an absolute advantage – in every sort of economic activity. Comparative advantage is about identifying which activities a country (or firm or individual) is most efficient at doing.
To see how this theory works imagine two countries, alpha and omega. Each country has 1,000 workers and can make two goods, computers and cars. Alpha’s economy is far more productive than omega’s. To make a car, alpha needs two workers, compared with omega’s four. To make a computer, alpha uses 10 workers, compared with omega’s 100. If there is no trade, and in each country half the workers are in each industry, alpha produces 250 cars and 50 computers and omega produces 125 cars and 5 computers.
What if the two countries specialize? Although alpha makes both cars and computers more efficiently than omega (it has an absolute advantage), it has a bigger edge in computer making. So it now devotes most of its resources to that industry, employing 700 workers to make computers and only 300 to make cars. This raises computer output to 70 and cuts car production to 150. Omega switches entirely to cars, turning out 250.
World output of both goods has risen. Both countries can consume more of both if they trade, but at what price? Neither will want to import what it could make more cheaply at home. So alpha will want at least 5 cars per computer, and omega will not give up more than 25 cars per computer. Suppose the terms of trade are fixed at 12 cars per computer and 120 cars are exchanged for 10 computers. Then alpha ends up with 270 cars and 60 computers, and omega with 130 cars and 10 computers. Both are better off than they would be if they did not trade.
This is true even though alpha has an absolute advantage in making both computers and cars. The reason is that each country has a different comparative advantage. Alpha’s edge is greater in computers than in cars. Omega, although a costlier producer in both industries, is a less expensive maker of cars. If each country specializes in products in which it has a comparative advantage, both will gain from trade.
In essence, the theory of comparative advantage says that it pays countries to trade because they are different. It is impossible for a country to have no comparative advantage in anything. It may be the least efficient at everything, but it will still have a comparative advantage in the industry in which it is relatively least bad.
There is no reason to assume that a country’s comparative advantage will be static. If a country does what it has a comparative advantage in and sees its income grow as a result, it can afford better education and infrastructure. These, in turn, may give it a comparative advantage in other economic activities in future.
To see how this theory works imagine two countries, alpha and omega. Each country has 1,000 workers and can make two goods, computers and cars. Alpha’s economy is far more productive than omega’s. To make a car, alpha needs two workers, compared with omega’s four. To make a computer, alpha uses 10 workers, compared with omega’s 100. If there is no trade, and in each country half the workers are in each industry, alpha produces 250 cars and 50 computers and omega produces 125 cars and 5 computers.
What if the two countries specialize? Although alpha makes both cars and computers more efficiently than omega (it has an absolute advantage), it has a bigger edge in computer making. So it now devotes most of its resources to that industry, employing 700 workers to make computers and only 300 to make cars. This raises computer output to 70 and cuts car production to 150. Omega switches entirely to cars, turning out 250.
World output of both goods has risen. Both countries can consume more of both if they trade, but at what price? Neither will want to import what it could make more cheaply at home. So alpha will want at least 5 cars per computer, and omega will not give up more than 25 cars per computer. Suppose the terms of trade are fixed at 12 cars per computer and 120 cars are exchanged for 10 computers. Then alpha ends up with 270 cars and 60 computers, and omega with 130 cars and 10 computers. Both are better off than they would be if they did not trade.
This is true even though alpha has an absolute advantage in making both computers and cars. The reason is that each country has a different comparative advantage. Alpha’s edge is greater in computers than in cars. Omega, although a costlier producer in both industries, is a less expensive maker of cars. If each country specializes in products in which it has a comparative advantage, both will gain from trade.
In essence, the theory of comparative advantage says that it pays countries to trade because they are different. It is impossible for a country to have no comparative advantage in anything. It may be the least efficient at everything, but it will still have a comparative advantage in the industry in which it is relatively least bad.
There is no reason to assume that a country’s comparative advantage will be static. If a country does what it has a comparative advantage in and sees its income grow as a result, it can afford better education and infrastructure. These, in turn, may give it a comparative advantage in other economic activities in future.
Competition
The more competition there is, the more likely are firms to be efficient and prices to be low. Economists have identified several different sorts of competition. Perfect competition is the most competitive market imaginable in which everybody is a price taker. Firms earn only normal profits, the bare minimum profit necessary to keep them in business. If firms earn more than this (excess profits) other firms will enter the market and drive the price level down until there are only normal profits to be made.
Most markets exhibit some form of imperfect or monopolistic competition. There are fewer firms than in a perfectly competitive market and each can to some degree create barriers to entry. Thus firms can earn some excess profits without a new entrant being able to compete to bring prices down.
The least competitive market is a monopoly, dominated by a single firm that can earn substantial excess profits by controlling either the amount of output in the market or the price (but not both). In this sense it is a price setter. When there are few firms in a market (oligopoly) they have the opportunity to behave as a monopolist through some form of collusion (see cartel). A market dominated by a single firm does not necessarily have monopoly power if it is a contestable market. In such a market, a single firm can dominate only if it produces as efficiently as possible and does not earn excess profits. If it becomes inefficient or earns excess profits, another more efficient or less profitable firm will enter the market and dominate it instead.
Most markets exhibit some form of imperfect or monopolistic competition. There are fewer firms than in a perfectly competitive market and each can to some degree create barriers to entry. Thus firms can earn some excess profits without a new entrant being able to compete to bring prices down.
The least competitive market is a monopoly, dominated by a single firm that can earn substantial excess profits by controlling either the amount of output in the market or the price (but not both). In this sense it is a price setter. When there are few firms in a market (oligopoly) they have the opportunity to behave as a monopolist through some form of collusion (see cartel). A market dominated by a single firm does not necessarily have monopoly power if it is a contestable market. In such a market, a single firm can dominate only if it produces as efficiently as possible and does not earn excess profits. If it becomes inefficient or earns excess profits, another more efficient or less profitable firm will enter the market and dominate it instead.
Demographics
People and the statistical study of them. In the 200 years since Thomas Malthus forecast that population growth would result in mass starvation, dire predictions based on demographic trends have come to be taken with a pinch of salt. Even so, demography does matter. In developed countries, economists have studied the impact of the post-war “baby-boomer” population bulge as it has grown older. In the 1980s, as the bulge dominated the workforce, it may have contributed to a sharp, if temporary, rise in unemployment in many countries. Boomers starting to save for retirement may have increased demand for shares, so fuelling the bull stock market of the 1990s; as they retire and sell their shares for spending money, they may cause a long bear market. Furthermore, as they become elderly and retire, health-care spending and retirement pensions are likely to eat up a growing share of GDP. To the extent that these are provided by the state, this will mean increasing public spending and higher taxes. But whether they are provided by the state or by the private sector, the ageing of baby-boomers will impose a growing financial burden on the younger workers that have to support them (see replacement rate). Economists have tried to measure the extent of this burden using generational accounting, which looks at the amount of wealth transferred from one generation to another over the lifetimes of the members of each generation.
Economists have also developed many different theories to explain why populations grow and why the fertility rate slowed sharply, to below the replacement rate, in many developed countries during the 1990s. One explanation is based on the notion that people have children so that there is somebody to look after them in old age. Fertility rates fell because the state increasingly looked after retired people, and infant mortality rates were lower so fewer births were required to ensure that there were some children around in the parental dotage. Also, with a lower probability of a child dying, it paid the parents to have fewer children and to channel their energy and resources into maximizing the human capital of the few. Alternatively, it may have had something to do with an important innovation: the cheap and easy availability of reliable contraception.
Economists have also developed many different theories to explain why populations grow and why the fertility rate slowed sharply, to below the replacement rate, in many developed countries during the 1990s. One explanation is based on the notion that people have children so that there is somebody to look after them in old age. Fertility rates fell because the state increasingly looked after retired people, and infant mortality rates were lower so fewer births were required to ensure that there were some children around in the parental dotage. Also, with a lower probability of a child dying, it paid the parents to have fewer children and to channel their energy and resources into maximizing the human capital of the few. Alternatively, it may have had something to do with an important innovation: the cheap and easy availability of reliable contraception.
Deposit insurance
Protection for your savings, in case your bank goes bust. Arrangements vary around the world, but in most countries deposit insurance is required by the government and paid for by banks (and, ultimately, their customers), which contribute a small slice of their assets to a central, usually government-run, insurance fund. If a bank defaults, this fund guarantees its customers’ deposits, at least up to a certain amount. By reassuring banks’ customers that their cash is protected, deposit insurance aims to prevent them from panicking and causing a bank run, and thereby reduces systemic risk. The United States introduced it in 1933, after a massive bank panic led to widespread bankruptcy, deepening its depression.
The downside of deposit insurance is that it creates a moral hazard. By insulating depositors from defaults, deposit insurance reduces their incentive to monitor banks closely. Also banks can take greater risks, safe in the knowledge that there is a state-financed safety net to catch them if they fall.
There are no easy solutions to this moral hazard. One approach is to monitor what banks do very closely. This is easier said than done, not least because of the high cost. Another is to ensure capital adequacy by requiring banks to set aside, just in case, specified amounts of capital when they take on different amounts of risk.
Alternatively, the state safety net could be shrunk, by splitting banks into two types: super-safe, government-insured “narrow banks” that stick to traditional business and invest only in secure assets; and uninsured institutions, “broad banks”, that could range more widely under a much lighter regulatory system. Savers who invested in a broad bank would probably earn much higher returns because it could invest in riskier assets; but they would also lose their shirts if it went bust.
Yet another possible answer is to require every bank to finance a small proportion of its assets by selling subordinated debt to other institutions, with the stipulation that the yield on this debt must not be more than so many (say 50) basis points higher than the rate on a corresponding risk-free instrument. Subordinated debt (uninsured certificates of deposit) is simply junior debt. Its holders are at the back of the queue for their money if the bank gets into trouble and they have no safety net. Investors will buy subordinated debt at a yield quite close to the risk-free interest rate only if they are sure the bank is low risk. To sell its debt, the bank will have to persuade informed investors of this. If it cannot convince them it cannot operate. This exploits the fact that bankers know more about banking than do their supervisors. It asks banks not to be good citizens but to look only to their profits. Unlike the present regime, it exploits all the available information and properly aligns everybody’s incentives. This ingenious idea was first tried in Argentina, where it became a victim of the country's economic, banking and political crisis of 2001-02 before it really had a chance to prove itself.
The downside of deposit insurance is that it creates a moral hazard. By insulating depositors from defaults, deposit insurance reduces their incentive to monitor banks closely. Also banks can take greater risks, safe in the knowledge that there is a state-financed safety net to catch them if they fall.
There are no easy solutions to this moral hazard. One approach is to monitor what banks do very closely. This is easier said than done, not least because of the high cost. Another is to ensure capital adequacy by requiring banks to set aside, just in case, specified amounts of capital when they take on different amounts of risk.
Alternatively, the state safety net could be shrunk, by splitting banks into two types: super-safe, government-insured “narrow banks” that stick to traditional business and invest only in secure assets; and uninsured institutions, “broad banks”, that could range more widely under a much lighter regulatory system. Savers who invested in a broad bank would probably earn much higher returns because it could invest in riskier assets; but they would also lose their shirts if it went bust.
Yet another possible answer is to require every bank to finance a small proportion of its assets by selling subordinated debt to other institutions, with the stipulation that the yield on this debt must not be more than so many (say 50) basis points higher than the rate on a corresponding risk-free instrument. Subordinated debt (uninsured certificates of deposit) is simply junior debt. Its holders are at the back of the queue for their money if the bank gets into trouble and they have no safety net. Investors will buy subordinated debt at a yield quite close to the risk-free interest rate only if they are sure the bank is low risk. To sell its debt, the bank will have to persuade informed investors of this. If it cannot convince them it cannot operate. This exploits the fact that bankers know more about banking than do their supervisors. It asks banks not to be good citizens but to look only to their profits. Unlike the present regime, it exploits all the available information and properly aligns everybody’s incentives. This ingenious idea was first tried in Argentina, where it became a victim of the country's economic, banking and political crisis of 2001-02 before it really had a chance to prove itself.
Depression
A bad, depressingly prolonged recession in economic activity. The textbook definition of a recession is two consecutive quarters of declining output. A slump is where output falls by at least 10%; a depression is an even deeper and more prolonged slump.
The most famous example is the great depression of the 1930s. After growing strongly during the “roaring 20s”, the American economy (among others) went into prolonged recession. Output fell by 30%. Unemployment soared and stayed high: in 1939 the jobless rate was still 17% of the workforce. Roughly half of the 25,000 banks in the United States failed. An attempt to stimulate growth, the new deal, was the most far-reaching example of active fiscal policy then seen and greatly extended the role of the state in the American economy. However, the depression only ended with the onset of preparations to enter the Second World War.
Why did the great depression happen? It is not entirely clear, but forgets the popular explanation: that it all went wrong with the Wall Street stock market crash of October 1929; that the slump persisted because policymakers just sat there; and that it took the new deal to put things right. As early as 1928 the Federal Reserve, worried about financial speculation and inflated stock prices, began raising interest rates. In the spring of 1929, industrial production started to slow; the recession started in the summer, well before the stock market lost half of its value between October 24th and mid-November. Coming on top of a recession that had already begun, the crash set the scene for a severe contraction but not for the decade-long slump that ensued.
So why did a bad downturn keep getting worse, year after year, not just in the United States but also around the globe? In 1929 most of the world was on the gold standard, which should have helped stabilize the American economy. As demand in the united states slowed its imports fell, its balance of payments moved further into surplus and gold should have flowed into the country, expanding the money supply and boosting the economy. But the fed, which was still worried about easy credit and speculation, dampened the impact of this adjustment mechanism, and instead the money supply got tighter. Governments everywhere, hit by falling demand, tried to reduce imports through tariffs, causing international trade to collapse. Then American banks started to fail and the fed let them. As the crisis of confidence spread more banks failed, and as people rushed to turn bank deposits into cash the money supply collapsed.
Bad monetary policy was abetted by bad fiscal policy. Taxes were raised in 1932 to help balance the budget and restore confidence. The new deal brought deposit insurance and boosted government spending, but it also piled taxes on business and sought to prevent excessive competition. Price controls were brought in, along with other anti-business regulations. None of this stopped – and indeed may well have contributed to – the economy falling into recession again in 1937–38, after a brief recovery starting in 1935.
The most famous example is the great depression of the 1930s. After growing strongly during the “roaring 20s”, the American economy (among others) went into prolonged recession. Output fell by 30%. Unemployment soared and stayed high: in 1939 the jobless rate was still 17% of the workforce. Roughly half of the 25,000 banks in the United States failed. An attempt to stimulate growth, the new deal, was the most far-reaching example of active fiscal policy then seen and greatly extended the role of the state in the American economy. However, the depression only ended with the onset of preparations to enter the Second World War.
Why did the great depression happen? It is not entirely clear, but forgets the popular explanation: that it all went wrong with the Wall Street stock market crash of October 1929; that the slump persisted because policymakers just sat there; and that it took the new deal to put things right. As early as 1928 the Federal Reserve, worried about financial speculation and inflated stock prices, began raising interest rates. In the spring of 1929, industrial production started to slow; the recession started in the summer, well before the stock market lost half of its value between October 24th and mid-November. Coming on top of a recession that had already begun, the crash set the scene for a severe contraction but not for the decade-long slump that ensued.
So why did a bad downturn keep getting worse, year after year, not just in the United States but also around the globe? In 1929 most of the world was on the gold standard, which should have helped stabilize the American economy. As demand in the united states slowed its imports fell, its balance of payments moved further into surplus and gold should have flowed into the country, expanding the money supply and boosting the economy. But the fed, which was still worried about easy credit and speculation, dampened the impact of this adjustment mechanism, and instead the money supply got tighter. Governments everywhere, hit by falling demand, tried to reduce imports through tariffs, causing international trade to collapse. Then American banks started to fail and the fed let them. As the crisis of confidence spread more banks failed, and as people rushed to turn bank deposits into cash the money supply collapsed.
Bad monetary policy was abetted by bad fiscal policy. Taxes were raised in 1932 to help balance the budget and restore confidence. The new deal brought deposit insurance and boosted government spending, but it also piled taxes on business and sought to prevent excessive competition. Price controls were brought in, along with other anti-business regulations. None of this stopped – and indeed may well have contributed to – the economy falling into recession again in 1937–38, after a brief recovery starting in 1935.
Developing countries
A euphemism for the world’s poor countries, also known, often optimistically, as emerging economies. Some four-fifths of the world’s 6 billion people already live in developing countries, many of them in abject poverty. Developing countries account for less than one-fifth of total world GDP.
Economists disagree about how likely--and how fast--developing countries are to become developed. Neo-classical economics predicts that poor countries will grow faster than richer ones. The reason is diminishing returns on capital. Since poor countries start with less capital, they should reap higher returns than a richer country with more capital from each slice of new investment. But this catch-up effect (or convergence) is not supported by the data. For one thing, there is, in fact, no such thing as a typical developing country. The official developing world includes the (sometimes) fast-growing Asian tigers and the poorest nations in Africa. Studies of the relationship between growth and GDP per head in rich and poor countries found no evidence that poorer countries grew faster. Indeed, if anything, poorer countries have grown more slowly.
Development economics has argued that this is because poor countries have unique problems that require different policy solutions from those offered by conventional developed-world economics. But new endogenous growth theory instead argues that there is conditional convergence. Hold constant such factors as a country’s fertility rate, its human capital and its government policies (proxied by the share of current government spending in GDP), and poorer countries generally grow faster than richer ones. Since, in reality, other factors are not constant (not all countries have the same level of human capital or the same government policies), absolute convergence does not happen.
Government policies seem to be crucial. Countries with broadly free-market policies – in particular, free trade and the maintenance of secure property rights--have raised their growth rates. (Although some economists argue that the Asian tigers are an exception to this free-market rule.) Open economies have grown much faster on average than closed economies. Higher public spending relative to GDP is usually associated with slower growth. Furthermore, high inflation is bad for growth and so is political instability. The poorest countries can indeed catch up. Their chances of doing so are maximized by policies that give a greater role to competition and incentives, at home and abroad.
Despite starting with a big disadvantage, there is evidence that some developing countries do not help themselves because they squander the resources they have. Institutions that produce effective governance of an economy are crucial. Those countries that use their resources well can grow quickly. Indeed, the world’s fastest-growing economies are a small subgroup of exceptional performers among the poor countries.
Economists disagree about how likely--and how fast--developing countries are to become developed. Neo-classical economics predicts that poor countries will grow faster than richer ones. The reason is diminishing returns on capital. Since poor countries start with less capital, they should reap higher returns than a richer country with more capital from each slice of new investment. But this catch-up effect (or convergence) is not supported by the data. For one thing, there is, in fact, no such thing as a typical developing country. The official developing world includes the (sometimes) fast-growing Asian tigers and the poorest nations in Africa. Studies of the relationship between growth and GDP per head in rich and poor countries found no evidence that poorer countries grew faster. Indeed, if anything, poorer countries have grown more slowly.
Development economics has argued that this is because poor countries have unique problems that require different policy solutions from those offered by conventional developed-world economics. But new endogenous growth theory instead argues that there is conditional convergence. Hold constant such factors as a country’s fertility rate, its human capital and its government policies (proxied by the share of current government spending in GDP), and poorer countries generally grow faster than richer ones. Since, in reality, other factors are not constant (not all countries have the same level of human capital or the same government policies), absolute convergence does not happen.
Government policies seem to be crucial. Countries with broadly free-market policies – in particular, free trade and the maintenance of secure property rights--have raised their growth rates. (Although some economists argue that the Asian tigers are an exception to this free-market rule.) Open economies have grown much faster on average than closed economies. Higher public spending relative to GDP is usually associated with slower growth. Furthermore, high inflation is bad for growth and so is political instability. The poorest countries can indeed catch up. Their chances of doing so are maximized by policies that give a greater role to competition and incentives, at home and abroad.
Despite starting with a big disadvantage, there is evidence that some developing countries do not help themselves because they squander the resources they have. Institutions that produce effective governance of an economy are crucial. Those countries that use their resources well can grow quickly. Indeed, the world’s fastest-growing economies are a small subgroup of exceptional performers among the poor countries.
Development economics
Spawned by the end of the colonial era in the 1950s and 1960s, a whole branch of economic theory grew up around the question of how to promote economic development in poor countries. The proposition on which development economics was built was that poor countries were intrinsically different from rich ones and so needed their own set of economic models. Some development economists argued, for instance, that the self-interested, rational individual (homo economicus) did not exist in traditional tribal societies. They claimed that because many poor countries had large agricultural populations and were often dependent on a few commodity exports for foreign exchange earnings, economic policies that suited rich countries would not work for them. With hindsight, much of this was misguided, and policies based on it had disastrous effects. Development economists believed that the state had to play a big role in fostering modernization. Instead, the result was huge, inefficient -bureaucracies riddled with corruption, massive budget deficits and rampant inflation. During the 1990s, most governments of developing countries started to reverse these policies and undo the damage they had done by introducing policies based on similar economic models to those that had worked in rich countries. However, the sequencing of these new policies seemed to make a big difference to how well they worked. Doing the right things in the right order is crucial.
Diminishing returns
The more you have, the smaller is the extra benefit you get from having even more; also known as diseconomies of scale (see economies of scale). For instance, when workers have a lot of capital giving them a little more may not increase their productivity anywhere near as much as would giving the same amount to workers who currently have little or no capital. This underpins the catch-up effect, whereby there is (supposedly) convergence between the rates of growth of developing countries and developed ones. In the new economy, some economists argue, capital may not suffer from diminishing returns, or at least the amount of diminishing will be much smaller. There may even be ever increasing returns.
Discounted cash flow
How much less is a sum of money due in the future worth today? The answer is found by -discounting the future cash flow, using an interest rate that reflects the fact that money in future is worth less than money now, because money now could be invested and earn interest, whereas future money cannot. Firms use discounted cash flow to judge whether an investment project is worthwhile. The interest rate is a means of reflecting the opportunity cost of tying up money in the investment project. To test whether an investment makes economic sense the income must be discounted so that it can be measured against the costs. If the present value of the benefits exceeds the costs, the investment is a good one.
Dividend
The part of a company’s profit distributed to shareholders. Unlike interest on debt, the payment of a dividend is not automatic. It is decided by the company’s managers, subject to the approval of the company’s owners (shareholders). However, when a company cuts its dividend, this usually triggers a sharp fall in its share price by more than would be appear to be justified by the reduced dividend. Economists theorise that this is because a dividend cut signals to shareholders that the company is in a bad way, with more bad news to follow.
Dumping
Selling something for less than the cost of producing it. This may be used by a dominant firm to attack rivals, a strategy known to antitrust authorities as predatory pricing. Participants in international trade are often accused of dumping by domestic firms charging more than rival imports. Countries can slap duties on cheap imports that they judge are being dumped in their markets. Often this amounts to thinly disguised protectionism against more efficient foreign firms.
In practice, genuine predatory pricing is rare – certainly much rarer than anti-dumping actions – because it relies on the unlikely ability of a single producer to dominate a world market. In any case, consumers gain from lower prices; so do companies that can buy their supplies more cheaply abroad.
In practice, genuine predatory pricing is rare – certainly much rarer than anti-dumping actions – because it relies on the unlikely ability of a single producer to dominate a world market. In any case, consumers gain from lower prices; so do companies that can buy their supplies more cheaply abroad.
Environmental economics
Some people think capitalism is wholly bad for the environment as it is based on consuming scarce resources. They want less consumption and greater reliance on renewable resources. They oppose free trade because they favour self-sufficiency (autarky), or at least so-called fair trade, and because they believe it encourages poorer countries to destroy their natural resources in order to get rich quick. Although few professional economists would share these views, in recent years many attempts have been made to incorporate environmental concerns within mainstream economics.
The traditional measure of GDP incorporates only those things that are paid for; this may include things that reduce the overall quality of life, including harming the environment. For instance, cleaning up an oil spill will increase GDP if people are paid for the clean-up. Attempts have been made to devise an alternative environmentally friendly measure of national income, but so far progress has been limited. At the very least, traditional economists increasingly agree that maximizing GDP growth does not necessarily equal maximizing social welfare.
Much of the damage done to the environment may be a result of externalities. An externality can arise when people engaged in economic activity do not have to take into account the full costs of what they are doing. For instance, car drivers do not have to bear the full cost of making their contribution to global warming, even though their actions may one day impose a huge financial burden on society. One way to reduce externalities is to tax them, say, through a fuel tax. Another is prohibition, say, limiting car drivers to one gallon of fuel per week. This could result in black markets, however. Allowing trade in pollution rights may encourage “efficient pollution”, with the pollution permits ending up in the hands of those for which pollution has the greatest economic upside. As this would still allow some environmental destruction, it might be unpopular with extreme greens.
There may be a case for international eco markets. For instance, people in rich countries might pay people in poor countries to stop doing activities that do environmental damage outside the poor countries, or that rich people disapprove of, such as chopping down the rain forests. Choices on environmental policy, notably on measures to reduce the threat of global warming, involve costs today with benefits delayed until the distant future. How are these choices to be made? Traditional cost-benefit analysis does not help much. In measuring costs and benefits in the far distant future, two main things seem to intervene and spoil the conventional calculations. One is uncertainty. We know nothing about what the state of the world will be in 2200. The other is how much people today are willing to pay in order to raise the welfare of others who are so remote that they can barely be imagined, yet who seem likely to be much better off materially than people today. Some economists take the view that the welfare of each future generation should be given the same weight in the analysis as the welfare of todays. This implies that a much lower discount rate should be used than the one appropriate for short-term projects. Another option is to use a high discount rate for costs and benefits arising during the first 30 or so years, then a lower rate or rates for more distant periods. Many studies by economists and psychologists have found that people do in fact discount the distant future at lower rates than they apply to the near future.
The traditional measure of GDP incorporates only those things that are paid for; this may include things that reduce the overall quality of life, including harming the environment. For instance, cleaning up an oil spill will increase GDP if people are paid for the clean-up. Attempts have been made to devise an alternative environmentally friendly measure of national income, but so far progress has been limited. At the very least, traditional economists increasingly agree that maximizing GDP growth does not necessarily equal maximizing social welfare.
Much of the damage done to the environment may be a result of externalities. An externality can arise when people engaged in economic activity do not have to take into account the full costs of what they are doing. For instance, car drivers do not have to bear the full cost of making their contribution to global warming, even though their actions may one day impose a huge financial burden on society. One way to reduce externalities is to tax them, say, through a fuel tax. Another is prohibition, say, limiting car drivers to one gallon of fuel per week. This could result in black markets, however. Allowing trade in pollution rights may encourage “efficient pollution”, with the pollution permits ending up in the hands of those for which pollution has the greatest economic upside. As this would still allow some environmental destruction, it might be unpopular with extreme greens.
There may be a case for international eco markets. For instance, people in rich countries might pay people in poor countries to stop doing activities that do environmental damage outside the poor countries, or that rich people disapprove of, such as chopping down the rain forests. Choices on environmental policy, notably on measures to reduce the threat of global warming, involve costs today with benefits delayed until the distant future. How are these choices to be made? Traditional cost-benefit analysis does not help much. In measuring costs and benefits in the far distant future, two main things seem to intervene and spoil the conventional calculations. One is uncertainty. We know nothing about what the state of the world will be in 2200. The other is how much people today are willing to pay in order to raise the welfare of others who are so remote that they can barely be imagined, yet who seem likely to be much better off materially than people today. Some economists take the view that the welfare of each future generation should be given the same weight in the analysis as the welfare of todays. This implies that a much lower discount rate should be used than the one appropriate for short-term projects. Another option is to use a high discount rate for costs and benefits arising during the first 30 or so years, then a lower rate or rates for more distant periods. Many studies by economists and psychologists have found that people do in fact discount the distant future at lower rates than they apply to the near future.
Equity
There are two definitions in economics.
1. The capital of a firm, after deducting any liabilities to outsiders other than shareholders, who are typically the legal owners of the firm’s equity. This ownership right is the reason shares are also known as equities.
2. Fairness. Dividing up the economic pie. Economists have been particularly interested in this with regard to how systems of taxation work. They have examined whether taxes treat fairly people with the same ability to pay (horizontal equity) and people with different abilities to pay (vertical equity).
The fairness of other aspects of how the gains from economic activity are distributed through society has also been debated by economists, especially those interested in welfare economics. Some economists start with the presumption that the free-market outcome is inherently inequitable, and that equity (sharing out the pie) must be traded off against efficiency (maximizing the size of the pie). Others argue that it is inequitable to take money away from someone who has created economic value to give to people who have been less skilled or industrious
1. The capital of a firm, after deducting any liabilities to outsiders other than shareholders, who are typically the legal owners of the firm’s equity. This ownership right is the reason shares are also known as equities.
2. Fairness. Dividing up the economic pie. Economists have been particularly interested in this with regard to how systems of taxation work. They have examined whether taxes treat fairly people with the same ability to pay (horizontal equity) and people with different abilities to pay (vertical equity).
The fairness of other aspects of how the gains from economic activity are distributed through society has also been debated by economists, especially those interested in welfare economics. Some economists start with the presumption that the free-market outcome is inherently inequitable, and that equity (sharing out the pie) must be traded off against efficiency (maximizing the size of the pie). Others argue that it is inequitable to take money away from someone who has created economic value to give to people who have been less skilled or industrious
European Union
A club of European countries. Initially a six-country trade area established by the 1957 treaty of Rome and known as the European Economic Community, it has become an increasingly political union. In 1999 a single currency, the euro, was launched in 11 of the then 15 member countries. Viewed as a single entity, the EU has a bigger economy than the United States. In 2002, a further 10 countries were invited to join the EU in 2004, increasing its membership to 25 countries, with more countries likely to follow later.
Exchange rate
The price at which one currency can be converted into another. Over the years, economists and politicians have often changed their minds about whether it is a good idea to try to hold a country’s exchange rate steady, rather than let it be decided by market forces. For two decades after the Second World War, many of the major currencies were fixed under the Breton Woods agreement. During the following two decades, the number of currencies allowed to float increased, although in the late 1990s a number of European currencies were permanently fixed under economic and monetary union and some other countries established a currency board.
When capital can flow easily around the world, countries cannot fix their exchange rate and at the same time maintain an independent monetary policy. They must choose between the confidence and stability provided by a fixed exchange rate and the control over interest rate policy offered by a floating exchange rate. On the face of it, in a world of capital mobility a more flexible exchange rate seems the best bet. A floating currency will force firms and investors to hedge against fluctuations, not lull them into a false sense of stability. It should make foreign banks more circumspect about lending. At the same time it gives policymakers the option of devising their own monetary policy. But floating exchange rates have a big drawback: when moving from one equilibrium to another, currencies can overshoot and become highly unstable, especially if large amounts of capital flow in or out of a country. This instability has real economic costs.
To get the best of both worlds, many emerging economies have tried a hybrid approach, loosely tying their exchange rate either to a single foreign currency, such as the dollar, or to a basket of currencies. But the currency crises of the late 1990s, and the failure of Argentina’s currency board, led many economists to conclude that, if not a currency union such as the euro, the best policy may be to have a freely floating exchange rate.
When capital can flow easily around the world, countries cannot fix their exchange rate and at the same time maintain an independent monetary policy. They must choose between the confidence and stability provided by a fixed exchange rate and the control over interest rate policy offered by a floating exchange rate. On the face of it, in a world of capital mobility a more flexible exchange rate seems the best bet. A floating currency will force firms and investors to hedge against fluctuations, not lull them into a false sense of stability. It should make foreign banks more circumspect about lending. At the same time it gives policymakers the option of devising their own monetary policy. But floating exchange rates have a big drawback: when moving from one equilibrium to another, currencies can overshoot and become highly unstable, especially if large amounts of capital flow in or out of a country. This instability has real economic costs.
To get the best of both worlds, many emerging economies have tried a hybrid approach, loosely tying their exchange rate either to a single foreign currency, such as the dollar, or to a basket of currencies. But the currency crises of the late 1990s, and the failure of Argentina’s currency board, led many economists to conclude that, if not a currency union such as the euro, the best policy may be to have a freely floating exchange rate.
Export credit
Loans to boost exports. In many countries these are subsidized by a government keen to encourage exports. Typically, the credit comes in two forms: loans to foreign buyers of domestic produce; and guarantees on loans made by banks to domestic companies so they can produce the exports that should pay off the loan. This effectively insures producers against non-payment. When governments compete aggressively with export credits to win business for domestic firms the sums involved can become large. The economic benefit of export credits is unclear at the best of times. This may be because they are largely motivated by political goals.
Externality
An economic side-effect. Externalities are costs or benefits arising from an economic activity that affect somebody other than the people engaged in the economic activity and are not reflected fully in prices. For instance, smoke pumped out by a factory may impose clean-up costs on nearby residents; bees kept to produce honey may pollinate plants belonging to a nearby farmer, thus boosting his crop. Because these costs and benefits do not form part of the calculations of the people deciding whether to go ahead with the economic activity they are a form of market failure, since the amount of the activity carried out if left to the free market will be an inefficient use of resources. If the externality is beneficial, the market will provide too little; if it is a cost, the market will supply too much.
One potential solution is regulation: a ban, say. Another, when the externality is negative, is a tax on the activity or, if the externality is positive, a subsidy. But the most efficient solution to externalities is to require them to be included in the costings of those engaged in the economic activity, so there is self-regulation. For instance, the externality of pollution can be solved by creating property rights over clean air, entitling their owner to a fee if they are infringed by a factory pumping out smoke. According to the Coase theorem (named after a Nobel Prize-winning economist, Ronald Coase), it does not matter who has ownership, so long as property rights are fully allocated and completely free trade of all property rights is possible.
One potential solution is regulation: a ban, say. Another, when the externality is negative, is a tax on the activity or, if the externality is positive, a subsidy. But the most efficient solution to externalities is to require them to be included in the costings of those engaged in the economic activity, so there is self-regulation. For instance, the externality of pollution can be solved by creating property rights over clean air, entitling their owner to a fee if they are infringed by a factory pumping out smoke. According to the Coase theorem (named after a Nobel Prize-winning economist, Ronald Coase), it does not matter who has ownership, so long as property rights are fully allocated and completely free trade of all property rights is possible.
Financial system
The firms and institutions that together make it possible for money to make the world go round. This includes financial markets, securities exchanges, banks, pension funds, mutual funds, insurers, national regulators, such as the Securities and Exchange Commission (SEC) in the United States, central banks, governments and multinational institutions, such as the IMF and World Bank.
Firms
For many years, economists had little interest in what happened inside firms, preferring instead to examine the workings of the different sorts of industries in which firms operate, ranging from perfect competition to monopoly. Since the 1960s, however, sophisticated economic theories of how firms work have been developed. These have examined why firms grow at different rates and tried to model the normal life cycle of a company, from fast-growing start-up to lumbering mature business. The aim is to explain when it pays to conduct an activity within a firm and when it pays to externalize it through short- or long-term arrangements with outsiders, be they individuals, exchanges or other companies. The theories also look at the economic consequences of the different incentives influencing individuals working within companies, tackling issues such as pay, agency costs and corporate governance structures.
Fiscal policy
One of the two instruments of macroeconomic policy; monetary policy's side-kick. It comprises public spending and taxation, and any other government income or assistance to the private sector (such as tax breaks). It can be used to influence the level of demand in the economy, usually with the twin goals of getting unemployment as low as possible without triggering excessive inflation. At times it has been deployed to manage short-term demand through fine tuning, although since the end of the Keynesian era it has more often been targeted on long-term goals, with monetary policy more often used for shorter-term adjustments.
For a government, there are two main issues in setting fiscal policy: what should be the overall stance of policy, and what form should its individual parts take?
Some economists and policymakers argue for a balanced budget. Others say that a persistent deficit (public spending exceeding revenue) is acceptable provided, in accordance with the golden rule, the deficit is used for investment (in infrastructure, say) rather than consumption. However, there may be a danger that public-sector investment will result in the crowding out of more productive private investment. Whatever the overall stance on average over an economic cycle, most economists agree that fiscal policy should be counter-cyclical, aiming to automatically stabilize demand by increasing public spending relative to revenue when the economy is struggling and increasing taxes relative to spending towards the top of the cycle. For instance, social (welfare) handouts from the state usually increase during tough times, and fiscal drag boosts government revenue when the economy is growing.
As for the bits and pieces making up fiscal policy, one debate is about how high public spending should be relative to GDP. In the United States and many Asian countries, public spending is less than 30% of GDP; in European countries, such as Germany and Sweden, it has been as high as 40-50%. Some economic studies suggest that lower public spending relative to GDP results in higher rates of growth, though this conclusion is controversial. Certainly, over the years, much public spending has been highly inefficient.
Another issue is the form that taxation should take, especially the split between direct taxation and indirect taxation and between capital, income and expenditure tax.
For a government, there are two main issues in setting fiscal policy: what should be the overall stance of policy, and what form should its individual parts take?
Some economists and policymakers argue for a balanced budget. Others say that a persistent deficit (public spending exceeding revenue) is acceptable provided, in accordance with the golden rule, the deficit is used for investment (in infrastructure, say) rather than consumption. However, there may be a danger that public-sector investment will result in the crowding out of more productive private investment. Whatever the overall stance on average over an economic cycle, most economists agree that fiscal policy should be counter-cyclical, aiming to automatically stabilize demand by increasing public spending relative to revenue when the economy is struggling and increasing taxes relative to spending towards the top of the cycle. For instance, social (welfare) handouts from the state usually increase during tough times, and fiscal drag boosts government revenue when the economy is growing.
As for the bits and pieces making up fiscal policy, one debate is about how high public spending should be relative to GDP. In the United States and many Asian countries, public spending is less than 30% of GDP; in European countries, such as Germany and Sweden, it has been as high as 40-50%. Some economic studies suggest that lower public spending relative to GDP results in higher rates of growth, though this conclusion is controversial. Certainly, over the years, much public spending has been highly inefficient.
Another issue is the form that taxation should take, especially the split between direct taxation and indirect taxation and between capital, income and expenditure tax.
Foreign direct investment
Investing directly in production in another country, either by buying a company there or establishing new operations of an existing business. This is done mostly by companies as opposed to financial institutions, which prefer indirect investment abroad such as buying small parcels of a country's supply of shares or bonds. Foreign direct investment (FDI) grew rapidly during the 1990s before slowing a bit, along with the global economy, in the early years of the 21st century. Most of this investment went from one OECD country to another, but the share going to developing countries, especially in Asia, increased steadily.
There was a time when economists considered FDI as a substitute for trade. Building factories in foreign countries was one way of jumping tariff barriers. Now economists typically regard FDI and trade as complementary. For example, a firm can use a factory in one country to supply neighboring markets. Some investments, especially in services industries, are essential prerequisites for selling to foreigners. Who would buy a big Mac in London if it had to be sent from New York?
Governments used to be highly suspicious of FDI, often regarding it as corporate imperialism. Nowadays they are more likely to court it. They hope that investors will create jobs, and bring expertise and technology that will be passed on to local firms and workers, helping to sharpen up their whole economy. Furthermore, unlike financial investors, multinationals generally invest directly in plant and equipment. Since it is hard to uproot a chemicals factory, these investments, once made, are far more enduring than the flows of hot money that whisk in and out of emerging markets mergers and acquisitions are a significant form of FDI. For instance, in 1997, more than 90% of FDI into the United States took the form of mergers rather than of setting up new subsidiaries and opening factories.
There was a time when economists considered FDI as a substitute for trade. Building factories in foreign countries was one way of jumping tariff barriers. Now economists typically regard FDI and trade as complementary. For example, a firm can use a factory in one country to supply neighboring markets. Some investments, especially in services industries, are essential prerequisites for selling to foreigners. Who would buy a big Mac in London if it had to be sent from New York?
Governments used to be highly suspicious of FDI, often regarding it as corporate imperialism. Nowadays they are more likely to court it. They hope that investors will create jobs, and bring expertise and technology that will be passed on to local firms and workers, helping to sharpen up their whole economy. Furthermore, unlike financial investors, multinationals generally invest directly in plant and equipment. Since it is hard to uproot a chemicals factory, these investments, once made, are far more enduring than the flows of hot money that whisk in and out of emerging markets mergers and acquisitions are a significant form of FDI. For instance, in 1997, more than 90% of FDI into the United States took the form of mergers rather than of setting up new subsidiaries and opening factories.
Game theory
How to win at twister? No, but maybe at monopoly. Game theory is a technique for analyzing how people, firms and governments should behave in strategic situations (in which they must interact with each other), and in deciding what to do must take into account what others are likely to do and how others might respond to what they do. For instance, competition between two firms can be analyzed as a game in which firms play to achieve a long-term competitive advantage (perhaps even a monopoly). The theory helps each firm to develop its optimal strategy for, say, pricing its products and deciding how much to produce; it can help the firm to anticipate in advance what its competitor will do and shows how best to respond if the competitor does something unexpected. It is particularly useful for understanding behavior in monopolistic competition.
In game theory, which can be used to describe anything from wage negotiations to arms races, a dominant strategy is one that will deliver the best results for the player, regardless of what anybody else does. One finding of game theory is that there may be a large first-mover advantage for companies that beat their rivals into a new market or come up with an innovation. One special case identified by the theory is the zero-sum game, where players see that the total winnings are fixed; for some to do well, others must lose. Far better is the positive-sum game, in which competitive interaction has the potential to make all the players richer. Another problem analyzed by game theorists is the prisoners' dilemma.
In game theory, which can be used to describe anything from wage negotiations to arms races, a dominant strategy is one that will deliver the best results for the player, regardless of what anybody else does. One finding of game theory is that there may be a large first-mover advantage for companies that beat their rivals into a new market or come up with an innovation. One special case identified by the theory is the zero-sum game, where players see that the total winnings are fixed; for some to do well, others must lose. Far better is the positive-sum game, in which competitive interaction has the potential to make all the players richer. Another problem analyzed by game theorists is the prisoners' dilemma.
Globalization
A buzz word that refers to the trend for people, firms and governments around the world to become increasingly dependent on and integrated with each other. This can be a source of tremendous opportunity, as new markets, workers, business partners, goods and services and jobs become available, but also of competitive threat, which may undermine economic activities that were viable before globalization.
The term first surfaced during the 1980s to characterize huge changes that were taking place in the international economy, notably the growth in international trade and in flows of capital around the world. Globalization has also been used to describe growing income inequality between the world's rich and poor; the growing power of multinational companies relative to national government; and the spread of capitalism into former communist countries. Usually, the term is synonymous with international integration, the spread of free markets and policies of liberalization and free trade. The process is not the result simply of economic forces. The decisions of policymakers have also played an important part, although not all governments have embraced the change warmly.
The driving force of globalization has been multinational companies, which since the 1970s have constantly, and often successfully, lobbied governments to make it easier for them to put their skills and capital to work in previously protected national markets. Firms enjoying some national protection, and their (often unionized) workers, have been some of the main opponents of globalization, along with advocates of fair trade.
Despite all the talk of globalization during the 1990s, in some respects the world economy was more integrated in the late 19th century. The labor market was certainly more global. For example, the flow of people out of Europe, 300,000 people a year in the mid-19th century, reached 1m a year after 1900. Now governments are much fussier about immigration, and people are no longer free to migrate as they wish. As for capital markets, only in the 1990s did international capital flows, relative to the size of the world economy, recover to the levels of the few decades before the first world war.
This early globalized economy did not last for long, however. Between the two world wars, the flows of trade, capital and people collapsed to a trickle. Even before the First World War, governments started to put up the shutters against migrants and imports. Could such a backlash against globalization happen again?
The term first surfaced during the 1980s to characterize huge changes that were taking place in the international economy, notably the growth in international trade and in flows of capital around the world. Globalization has also been used to describe growing income inequality between the world's rich and poor; the growing power of multinational companies relative to national government; and the spread of capitalism into former communist countries. Usually, the term is synonymous with international integration, the spread of free markets and policies of liberalization and free trade. The process is not the result simply of economic forces. The decisions of policymakers have also played an important part, although not all governments have embraced the change warmly.
The driving force of globalization has been multinational companies, which since the 1970s have constantly, and often successfully, lobbied governments to make it easier for them to put their skills and capital to work in previously protected national markets. Firms enjoying some national protection, and their (often unionized) workers, have been some of the main opponents of globalization, along with advocates of fair trade.
Despite all the talk of globalization during the 1990s, in some respects the world economy was more integrated in the late 19th century. The labor market was certainly more global. For example, the flow of people out of Europe, 300,000 people a year in the mid-19th century, reached 1m a year after 1900. Now governments are much fussier about immigration, and people are no longer free to migrate as they wish. As for capital markets, only in the 1990s did international capital flows, relative to the size of the world economy, recover to the levels of the few decades before the first world war.
This early globalized economy did not last for long, however. Between the two world wars, the flows of trade, capital and people collapsed to a trickle. Even before the First World War, governments started to put up the shutters against migrants and imports. Could such a backlash against globalization happen again?
Gold
For much of human history gold has been an important ingredient of economic activity. But its importance declined during the 20th century and may continue to shrink in future. The gold standard, which fixed exchange rates to the value of gold during the 19th and early 20th centuries, has been long abandoned. Central banks, which in 2000 still owned 30,000 tonnes, over one-quarter of all the gold ever mined, no longer feel the need to have large reserves of the metal to support the value of their currency. It does not pay them any interest, though they may earn a little by lending it to bullion dealers. So they have started to sell.
Governments and investors have traditionally held gold as a hedge against inflation and to provide security at times of international crisis. But its role as a store of value has been tarnished. During the 1980s and 1990s, the value of gold generally failed to keep pace with inflation. The liquidity of gold is also less than that of a foreign currency so it cannot as easily be used for foreign exchange intervention in defense of a currency under attack. In short, gold is no longer a monetary asset. It has become just another commodity, although so-called gold-bugs still believe that should inflation ever soar again, gold will once more become the thing to have.
Governments and investors have traditionally held gold as a hedge against inflation and to provide security at times of international crisis. But its role as a store of value has been tarnished. During the 1980s and 1990s, the value of gold generally failed to keep pace with inflation. The liquidity of gold is also less than that of a foreign currency so it cannot as easily be used for foreign exchange intervention in defense of a currency under attack. In short, gold is no longer a monetary asset. It has become just another commodity, although so-called gold-bugs still believe that should inflation ever soar again, gold will once more become the thing to have.
Gold standard
A monetary system in which a country backs its currency with a reserve of gold, and allows currency holders to exchange their notes and coins for gold. For many years up to 1914, most of the world's leading currencies had their exchange rate determined by the gold standard. The economic disruption resulting from the First World War led the combatants to abandon the link to gold. The UK (with others) returned to the gold standard in 1925, before quitting it for good in 1931. The widespread use of the gold standard ended during 1930-33 as a result of global depression and large cuts in international lending. The United States left the gold standard in 1933 and partially returned to it in 1934. After the Second World War, a limited form of gold standard continued but only directly applied to the dollar; other major currencies had their exchange rates fixed to the dollar under the Breton Woods arrangements. The dollar was finally cut loose from the gold standard in 1971.
Golden rule
Over the economic cycle, a government should borrow only to invest and not to finance current spending. This rule is certainly a prudent approach to fiscal policy, provided that governments are honest in describing spending as investment, that they invest in appropriate things and do so efficiently, and that they are careful to avoid crowding out superior private investment. But there are other fiscal policy options that may make as much sense. See, for example, balanced budget.
Hard currency
Money you can trust. A hard currency is expected to retain its value, or even benefit from appreciation, against softer currencies. This makes it a popular choice for people involved in international transactions. The dollar, d-mark, sterling and the Swiss Franc each became a hard currency, if only some of the time, during the 20th century.
Human capital
The stuff that enables people to earn a living. Human capital can be increased by investing in education, training and health care. Economists increasingly argue that the accumulation of human as well as physical capital (plant and machinery) is a crucial ingredient of economic growth, par¬ticularly in the new economy. Even so, this conclusion is largely a matter of theory and faith, rather than the result of detailed empirical analysis. Economists have made little progress in solving the tricky problem of how to measure human capital, even within the same country over time, let alone for comparisons between countries. Levels of spending on, say, education are not necessarily a good indicator of how much human capital an education system is creating; indeed, some economists argue that higher education spending may be a consequence of a country becoming wealthy rather than a cause. Never the less, even modest estimates of the stock of human capital in most countries suggests that it would pay to greatly increase investment in medical technologies that would extend the working lives of most people. The non-economic benefits would be worth having, too.
Hyper-inflation
Very, very bad. Although people debate when, precisely, very rapid inflation turns into -hyper-inflation (a 100% or more increase in prices a year, perhaps?) Nobody questions that it wreaks huge economic damage. After the first world war, German prices at one point were rising at a rate of 23,000% a year before the country’s economic system collapsed, creating a political opportunity grasped by the Nazis. In former Yugoslavia in 1993, prices rose by around 20% a day. Typically, hyper-inflation quickly leads to a complete loss of confidence in a country’s currency, and causes people to search for other forms of money that are a better store of value. These may include physical assets, gold and foreign currency. Hyper-inflation might be easier to live with if it was stable, as people could plan on the basis that prices would raise at a fast but predictable rate. However, there are no examples of stable hyper-inflation, precisely because it occurs only when there is a crisis of confidence across the economy, with all the behavioral unpredictability this implies.
IMF
Short for international monetary fund, referee and, when the need arises, rescuer of the world’s financial system. The IMF was set up in 1944 at Bretton Woods, along with the World Bank, to supervise the newly established fixed exchange rate system. After this fell apart in 1971–73, the IMF became more involved with its member countries’ economic policies, doling out advice on fiscal policy and monetary policy as well as microeconomic changes such as privatization, of which it became a forceful advocate. In the 1980s, it played a leading part in sorting out the problems of developing countries’ mounting debt. More recently, it has several times co-ordinate and helped to finance assistance to countries with a currency crisis.
The fund has been criticized for the conditionality of its support, which is usually given only if the recipient country promises to implement IMF-approved economic reforms. Unfortunately, the IMF has often approved “one size fits all” policies that, not much later, turned out to be inappropriate. It has also been accused of creating moral hazard, in effect encouraging governments (and firms, banks and other investors) to behave recklessly by giving them reason to expect that if things go badly the IMF will organize a bail-out. Indeed, some financiers have described an investment in a financially shaky country as a “moral-hazard play” because they were so confident that the IMF would ensure the safety of their money, one way or another. Following the economic crisis in Asia during the late 1990s, and again after the crisis in Argentina early in this decade, some policymakers argued (to no avail) for the IMF to be abolished, as the absence of its safety net would encourage more prudent behavior all round. More sympathetic folk argued that the IMF should evolve into a global lender of last resort.
The fund has been criticized for the conditionality of its support, which is usually given only if the recipient country promises to implement IMF-approved economic reforms. Unfortunately, the IMF has often approved “one size fits all” policies that, not much later, turned out to be inappropriate. It has also been accused of creating moral hazard, in effect encouraging governments (and firms, banks and other investors) to behave recklessly by giving them reason to expect that if things go badly the IMF will organize a bail-out. Indeed, some financiers have described an investment in a financially shaky country as a “moral-hazard play” because they were so confident that the IMF would ensure the safety of their money, one way or another. Following the economic crisis in Asia during the late 1990s, and again after the crisis in Argentina early in this decade, some policymakers argued (to no avail) for the IMF to be abolished, as the absence of its safety net would encourage more prudent behavior all round. More sympathetic folk argued that the IMF should evolve into a global lender of last resort.
Income tax
A much-loathed method of taxation based on earnings. It was first collected in 1797 by the Dutch Batavian republic. In the UK it was introduced in 1799 as a “temporary” measure to finance a war against napoleon, abolished in 1816 and reintroduced, forever, in 1842. In most countries, people do not pay it until their income exceeds a minimum threshold, and richer people pay a higher rate of income tax than poorer people. Since the 1980s, the unpopularity with voters of high rates of income tax and concern that high rates discourage valuable economic activity have led many governments to reduce income-tax rates. However, this has not necessarily reduced the amount of total revenue collected in income tax. Nor do governments that have reduced income tax rates always cut other sorts of taxes; on the contrary, they have often increased them sharply to make up for any revenue lost as a result of lower rates of income tax.
Index numbers
Economists love to compile indices aggregating lots of individual data, so they can analyse broad trends in the behavior of an economy. Inflation is measured by an index of consumer (retail) prices. There are Indices of all sorts of things that are bought and sold of which perhaps the best known are share price Indices like the Dow Jones industrial average or FTSE-100. The main challenges in compiling an index are what, exactly, to include in it and what weight to give the different things that are included. A particularly tricky question is how to change an index over time. Measures of inflation are based on the price of a basket of things bought by a typical consumer. As the quality and choice of products in the basket change over time, the inflation index ought to take this into account. How, exactly, is much debated.
Indirect taxation
Taxes that do not come straight out of a person’s pay packet or assets, or out of company profit. For example, a consumption tax, such as value-added tax. Contrast with direct taxation, such as income tax. Indirect taxation has become increasingly popular with politicians because it may be less noticeable to people paying it than income tax and is harder to avoid paying.
Inequality
Does economic growth create more or less equality? Do unequal societies grow more or less slowly than equal ones? Economists have debated these questions for as long as anyone can remember. One problem is to agree which sort of inequality matters: equality of outcome (that is, income) or of opportunity? Another is how then to measure it. Equality of opportunity, which, in theory, should make a difference to growth, because it is about giving people the chance to make the most of their human capital, is probably beyond the ability of statisticians to analyse rigorously. The most often used measure of income inequality is the gini coefficient.
The evidence suggests that extreme poverty is more likely to slow growth than income inequality itself. This is because very poor people cannot buy the education they need to enable them to become richer and their children may be forced to forgo schooling in order to work for money.
Economic growth has generally reduced inequality within a country. This has been partly as a result of redistributive tax and benefits systems, which have become so significant that they may now be causing slower growth in some countries. The availability of welfare benefits may have discouraged unemployed people from seeking out a better job; and the high taxes needed to pay for the benefits may have discouraged some wealthy people from working as hard as they would have done under a friendlier tax regime. However, the new economy may see inequality in rich countries widen again, thanks to its alleged winner-takes-all distribution of financial rewards.
The evidence suggests that extreme poverty is more likely to slow growth than income inequality itself. This is because very poor people cannot buy the education they need to enable them to become richer and their children may be forced to forgo schooling in order to work for money.
Economic growth has generally reduced inequality within a country. This has been partly as a result of redistributive tax and benefits systems, which have become so significant that they may now be causing slower growth in some countries. The availability of welfare benefits may have discouraged unemployed people from seeking out a better job; and the high taxes needed to pay for the benefits may have discouraged some wealthy people from working as hard as they would have done under a friendlier tax regime. However, the new economy may see inequality in rich countries widen again, thanks to its alleged winner-takes-all distribution of financial rewards.
Information
The oil that keeps the economy working smoothly. Economic efficiency is likely to be greatest when information is comprehensive, accurate and cheaply available. Many of the problems facing economies arise from people making decisions without all the information they need. One reason for the failure of the command economy is that government planners were not good at gathering and processing information. Adam smith’s metaphor of the invisible hand is all about how, in many cases, free markets are much more efficient at processing information on the needs of all the participants in an economy than is the visible, and often dead, hand of state planners. Asymmetric information, when one party to a deal knows more than the other party, can be a serious source of inefficiency and market failure. Uncertainty can also impose large economic costs. The internet, by greatly increasing the availability and lowering the price of information, is helping to boost economic efficiency. But there are inefficiencies the internet will not be able to solve. Uncertainty will remain a huge source of economic inefficiency. Alas, potentially the most useful information, about what will happen in the future, is never available until it is too late.
Insider trading
A practice that was made illegal in the united states in 1934 and in the uk in 1980, and is now banned (for shares, at least) in most countries. Insider trading involves using information that is not in the public domain but that will move the price of a share, bond or currency when it is made public. An insider trade takes place when someone with privileged, confidential access to that information trades to take advantage of the fact that prices will move when the news gets out. This is frowned on because investors may lose confidence in financial markets if they see insiders taking advantage of advantageous asymmetric information to enrich themselves at the expense of outsiders. But some economists reckon that insider trading leads to more efficient markets: by transmitting the inside information to the market, it makes the price of, say, a company’s shares more accurate. This may be true, but most financial regulators are willing to sacrifice a degree of accuracy in pricing to ensure that outsiders (the great majority of investors) feel they are being treated fairly.
Insurance
In economic terms, anything used to reduce the downside of risk. In its most familiar form, insurance is provided through a policy purchased from an insurance company. But a fuller definition would also include, say, a financial security (or anything else) used to hedge, as well as assistance available in the event of disaster. It could even be provided by the government, in various ways, including welfare payments to sick or poor people and legal protection from creditors in the event of bankruptcy.
Conventional insurance works by pooling the risks of many people (or firms, and so on), all of whom might claim but in practice only a few actually do. The cost of providing assistance to those that claim is spread over all the potential claimants, thus making the insurance affordable to all.
Despite the enormous attraction of insurance, private markets in insurance often work badly, or not at all. Economists have identified three main reasons for this.
• private firms are unwilling to provide insurance if they are uncertain about the likely cost of providing sufficient cover, especially if it is potentially unlimited.
• moral hazard means that people with insurance may take greater risks because they know they are protected, so the insurer may get a bigger bill than it bargained for.
• insurers are at risk of adverse selection. The people who are most likely to claim buy insurance, and those who are least likely to claim do not buy it. In this situation, setting a price for insurance that will generate enough premiums to cover all claims is tricky, if not impossible.
Insurers have found ways of reducing the impact of these problems. For example, to counter adverse selection, they set higher health-insurance rates for people who smoke. To limit moral hazard, they offer reduced premiums to people who agree to pay the first so-many dollars or pounds of any claim.
An efficient system of insurance, in its broadest sense, can contribute to economic growth by encouraging entrepreneurial risk taking and by enabling people to choose which risks they take and which they protect themselves against.
Conventional insurance works by pooling the risks of many people (or firms, and so on), all of whom might claim but in practice only a few actually do. The cost of providing assistance to those that claim is spread over all the potential claimants, thus making the insurance affordable to all.
Despite the enormous attraction of insurance, private markets in insurance often work badly, or not at all. Economists have identified three main reasons for this.
• private firms are unwilling to provide insurance if they are uncertain about the likely cost of providing sufficient cover, especially if it is potentially unlimited.
• moral hazard means that people with insurance may take greater risks because they know they are protected, so the insurer may get a bigger bill than it bargained for.
• insurers are at risk of adverse selection. The people who are most likely to claim buy insurance, and those who are least likely to claim do not buy it. In this situation, setting a price for insurance that will generate enough premiums to cover all claims is tricky, if not impossible.
Insurers have found ways of reducing the impact of these problems. For example, to counter adverse selection, they set higher health-insurance rates for people who smoke. To limit moral hazard, they offer reduced premiums to people who agree to pay the first so-many dollars or pounds of any claim.
An efficient system of insurance, in its broadest sense, can contribute to economic growth by encouraging entrepreneurial risk taking and by enabling people to choose which risks they take and which they protect themselves against.
