Adaptive expectations

A theory of how people from their views about the future that assumes they do so using past trends and the errors in their own earlier predictions. Contrast with rational expectations.

Agriculture

Farming around the world continues to become more productive while generally accounting for a smaller share of employment and national income, although in some poor countries it remains the sector on which the country and its people depend. Farming, forestry and fishing in 1913 accounted for 28% of employment in the united states, 41% in France and 60% in Japan, but only 12% in the UK. Now the proportion of the workforce employed in such activities has dropped below 6% in these and most other industrialized countries.
The total value of international trade in agriculture has risen steadily. But the global agriculture market remains severely distorted by trade barriers and government subsidy, such as the European Union's common agricultural policy.

Altruism

It is often alleged that altruism is inconsistent with economic rationality, which assumes that people behave selfishly. Certainly, much economic analysis is concerned with how individuals behave, and homo economicus (economic man) is usually assumed to act in his or her self-interest. However, self-interest does not necessarily mean selfish. Some economic models in the field of behavioral economics assume that self-interested individuals behave altruistically because they get some benefit, or utility, from doing so. For instance, it may make them feel better about themselves, or be a useful insurance policy against social unrest, say. Some economic models go further and relax the traditional assumption of fully rational behaviour by simply assuming that people sometimes behave altruistically, even if this may be against their self-interest. Either way, there is much economic literature about charity, international aid, public spending and redistributive taxation.

Amortisation

The running down or payment of a loan by installments. An example is a repayment mortgage on a house, which is amortized by making monthly payments that over a pre-agreed period of time cover the value of the loan plus interest. With loans that are not amortized, the borrower pays only interest during the period of the loan and then repays the sum borrowed in full.

Appreciation

A rise in the value of an asset and the opposite of depreciation. When the value of a currency rises relative to another, it appreciates.

Arbitrage pricing theory

This is one of two influential economic theories of how assets are priced in the financial markets. The other is the capital asset pricing model. The arbitrage pricing theory says that the price of a financial asset reflects a few key risk factors, such as the expected rate of interest, and how the price of the asset changes relative to the price of a portfolio of assets. If the price of an asset happens to diverge from what the theory says it should be, arbitrage by investors should bring it back into line.

Assets

Things that have earning power or some other value to their owner.

Asymmetric shock

When something unexpected happens that affects one economy (or part of an economy) more than the rest. This can create big problems for policymakers if they are trying to set a macroeconomic policy that works for both the area affected by the shock and the unaffected area. For instance, some economic areas may be oil exporters and thus highly dependent on the price of oil, but other areas are not. If the oil price plunges, the oil-dependent area would benefit from policies designed to boost demand that might be unsuited to the needs of the rest of the economy. This may be a constant problem for those responsible for setting the interest rate for the euro given the big differences--and different potential exposures to shocks--among the economies within the euro zone.

Austrian economics

A brand of neo-classical economics established in Vienna during the late 19th century and the first half of the 20th century. It was strongly opposed to Marxism and, more broadly, to the use of economic theories to justify government intervention in the economy. Prominent members included Friedrich Hayek, Joseph Schumpeter and Ludwig von Mises. It gave birth to the definition of economics as the science of studying human behavior as a relationship between ends and scarce means that have alternative uses. Austrian economic thinking was characterized by attributing all economic activity, including the behavior of apparently impersonal institutions, to the wishes and actions of individuals. It did this by examining choices in terms of their opportunity cost (that is, what is the next best use of resources to that which is being considered?) And by analyzing the impact of timing on decision making.
Hayek correctly predicted the failure of soviet-style central planning. His ideas are said to have inspired many of the free-market reforms carried out during the 1980s in the United States under Ronald Reagan and in the UK under Margaret Thatcher. Schumpeter developed a theory of innovation and economic change characterized by the phrase creative destruction.

Autarky

The idea that a country should be self-sufficient and not take part in international trade. The experience of countries that have pursued this utopian ideal by substituting domestic production for imports is an unhappy one. No country has been able to produce the full range of goods demanded by its population at competitive prices. Indeed, those that have tried to do so have condemned themselves to inefficiency and comparative poverty, compared with countries that engage in international trade.

Backwardation

When a commodity is valued more highly in a spot market (that is, when it is for delivery today) than in a futures market (for delivery at some point in the future). Normally, interest costs mean that futures prices are higher than spot prices, unless the markets expect the price of the commodity to fall over time, perhaps because there is a temporary bottleneck in supply. When spot prices are lower than futures prices it is known as contango.

Balanced budget

When total public-sector spending equals total government income during the same period from taxes and charges for public services. Politicians in some countries, such as the united states, have argued that government should be required to run a balanced budget in order to have sound public finances. However, there is no economic reason why public borrowing need necessarily be bad. For instance, if the debt is used to invest in things that will increase the growth rate of the economy--infrastructure, say, or education--it may be justified. It may also make more economic sense to try to balance the budget on average over an entire economic cycle, with public-sector deficits boosting the economy during recession and surpluses stopping it overheating during booms, than to balance it every year.

Bankruptcy

When a court judges that a debtor is unable to make the payments owed to a creditor. How bankrupts are treated can affect economic growth. If bankrupts are punished too severely, would-be entrepreneurs may be discouraged from taking the financial risks needed to make the most of their ideas. However, letting off defaulting debtors too readily may discourage potential creditors because of moral hazard.
America's bankruptcy code, in particular its chapter 11 protection for firms from their creditors, is particularly friendly to troubled borrowers, allowing them to borrow more money and giving them time to work out their problems. Some other countries quickly close down a bankrupt firm, and try to repay its debts by selling off any assets it has.

Barriers to entry (or exit)

How firms keep out competition--an important source of incumbent advantage. There are four main sorts of barriers.
*a firm may own a crucial resource, such as an oil well, or it may have an exclusive operating licence, for instance, to broadcast on a particular radio wavelength.
*a big firm with economies of scale may have a significant competitive advantage because it can produce a large output at lower costs than can a smaller potential rival.
*an incumbent firm may make it hard for a would-be entrant by incurring huge sunk costs, spending lots of money on things such as advertising, which any rival must match to compete effectively but which have no value if the attempt to compete should fail.
*powerful firms can discourage entry by raising exit costs, for example, by making it an industry norm to hire workers on long-term contracts, which make firing an expensive process.

Barter

Paying for goods or services with other goods or services, instead of with money. It is often popular when the quality of money is low or uncertain, perhaps because of high inflation or counterfeiting, or when people are asset-rich but cash-poor, or when taxation or extortion by criminals is high. Little wonder, then, that barter became popular in Russia during the late 1990s.

Basel 1 and 2

An attempt to reduce the number of bank failures by tying a bank's capital adequacy ratio to the riskiness of the loans it makes. For instance, there is less chance of a loan to a government going bad than a loan to, say, an internet business, so the bank should not have to hold as much capital in reserve against the first loan as against the second. The first attempt to do this worldwide was by the Basel committee for international banking supervision in 1988. However, its system of judging the relative riskiness of different loans was crude. For instance, it penalized banks no more for making loans to a fly-by-night software company in Thailand than to Microsoft; no more for loans to South Korea, bailed out by the IMF in 1998, than to Switzerland. In 1998, "Basel 2" was proposed, using much more sophisticated risk classifications. However, controversy over these new classifications, and the cost to banks of administering the new approach, led to the introduction of Basel 2 being delayed until (at least) 2005.

Basis point

One one-hundredth of a percentage point. Small movements in the interest rate, the exchange rate and bond yields are often described in terms of basis points. If a bond yield moves from 5.25% to 5.45%, it has risen by 20 basis points.

Bear

An investor who thinks that the price of a particular security or class of securities (shares, say) is going to fall; the opposite of a bull.

Behavioural economics

A branch of economics that concentrates on explaining the economic decisions people make in practice, especially when these conflict with what conventional economic theory predicts they will do. Behaviourists try to augment or replace traditional ideas of economic rationality (homo economicus) with decision-making models borrowed from psychology. According to psychologists, people are disproportionately influenced by a fear of feeling regret and will often forgo benefits even to avoid only a small risk of feeling they have failed. They are also prone to cognitive dissonance, often holding on to a belief plainly at odds with new evidence, usually because the belief has been held and cherished for a long time. Then there is anchoring: people are often overly influenced by outside suggestion. People apparently also suffer from status quo bias: they are willing to take bigger gambles to maintain the status quo than they would be to acquire it in the first place.
Traditional utility theory assumes that people make individual decisions in the context of the big picture. But psychologists have found that they generally compartmentalise, often on superficial grounds. They then make choices about things in one particular mental compartment without taking account of the implications for things in other compartments.
There is lots of evidence that people are persistently and irrationally overconfident. They are also vulnerable to hindsight bias: once something happens they overestimate the extent to which they could have predicted it. Many of these traits are captured in prospect theory, which is at the heart of much of behavioural economics.

Black economy

If you pay your cleaner or builder in cash, or for some reason neglect to tell the taxman that you were paid for a service rendered, you participate in the black or underground economy. Such transactions do not normally show up in the figures for GDP, so the black economy may mean that a country is much richer than the official data suggest. In the United States and the UK, the black economy adds an estimated 5—10% to GDP; in Italy, it may add 30%. As for Russia, in the late 1990s estimates of the black economy ranged as high as 50% of GDP.

Black-Scholes

A formula for pricing financial options. Its invention allowed a previously undreamed of precision in the pricing of options (which had hitherto been done using crude rules of thumb), and probably made possible the explosive growth in the markets for options and other derivatives that took place after the formula became widely used in the early 1970s. Myron Scholes and Robert Merton were awarded the Nobel Prize for economics for their part in devising the formula; their co-inventor, Fischer black (1938—95), was ineligible, having died.

Bounded rationality

A theory of human decision making that assumes that people behave rationally, but only within the limits of the information available to them. Because their information may be inadequate (bounded) they make take decisions that appear to be irrational according to traditional theories about homo economicus (economic man).

Brand

The stalking-horse for international capitalism. A focus for all the worries about environmental damage, human-rights abuses and sweated labor that opponents of globalization like to put on their placards. A symbol of America’s corporate power, since most of the world's best-known brands, from coca cola to Nike, are American. That is the case against.
Many economists regard brands as a good thing, however. A brand provides a guarantee of reliability and quality. Consumer trust is the basis of all brand values. So companies that own the brands have an immense incentive to work to retain that trust. Brands have value only where consumers have choice. The arrival of foreign brands, and the emergence of domestic brands, in former communist and other poorer countries points to an increase in competition from which consumers gain. Because a strong brand often requires expensive advertising and good marketing, it can raise both price and barriers to entry. But not to insuperable levels: brands fade as tastes change; if quality is not maintained, neither is the brand.

Bull

An investor who expects the price of a particular security to rise; the opposite of a bear.

Business confidence

How the people who run companies feel about their organisations' prospects. In many countries, surveys measure average business confidence. These can provide useful signs about the current condition of the economy, because companies often have information about consumer demand sooner than government statisticians do.

Buyer's market

A market in which supply seems plentiful and prices seem low; the opposite of a seller's market.

Cannibalise

Eating people is wrong. Eating your own business may not be. Firms used to be reluctant to launch new products and services that competed with what they were already doing, as the new thing would eat into (cannibalise) their existing business. In today's innovative, technology-intensive economy, however, a willingness to cannibalise is more often seen as a good thing. This is because innovation often takes the form of what economists call creative destruction, in which a superior new product destroys the market for existing products. In this environment, the best course of action for successful firms that want to avoid losing their market to a rival with an innovation may be to carry out the creative destruction themselves.

Capacity

The amount a company or an economy can produce using its current equipment, workers, capital and other resources at full tilt. Judging how close an economy is to operating at full capacity is an important ingredient of monetary policy, for if there is not enough spare capacity to absorb an increase in demand, prices are likely to rise instead. Measuring an economy’s output gap – how far current output is above or below what it would be at full capacity – is difficult, if not impossible, which is why even the best-intentioned central bank can struggle to keep down inflation. When there is too much spare capacity, however, the result can be deflation, as firms and employees cut their prices and wage demands to compete for whatever demand there may be.

Capital adequacy ratio

The ratio of a bank’s capital to its total assets, required by regulators to be above a minimum (“adequate”) level so that there is little risk of the bank going bust. How high this minimum level is may vary according to how risky a bank’s activities are.

Capital flight

When capital flows rapidly out of a country, usually because something happens which causes investors suddenly to lose confidence in its economy. (strictly speaking, the problem is not so much the money leaving, but rather that investors in general suddenly lower their valuation of all the assets of the country.) This is particularly worrying when the flight capital belongs to the country’s own citizens. This is often associated with a sharp fall in the exchange rate of the abandoned country’s currency.

Capital gains

The profit from the sale of a capital asset, such as a share or a property. Capital gains are subject to taxation in most countries. Some economists argue that capital gains should be taxed lightly (if at all) compared with other sources of income. They argue that the less tax is levied on capital gains, the greater is the incentive to put capital to productive use. Put another way, capital gains tax is effectively a tax on capitalism. However, if capital gains are given too friendly a treatment by the tax authorities, accountants will no doubt invent all sorts of creative ways to disguise other income as capital gains.

Capital intensive

A production process that involves comparatively large amounts of capital; the opposite of labour intensive.

Capital markets

Markets in securities such as bonds and shares. Governments and companies use them to raise longer-term capital from investors, although few of the millions of capital-market transactions every day involve the issuer of the security. Most trades are in the secondary markets, between investors who have bought the securities and other investors who want to buy them. Contrast with money markets, where short-term capital is raised.

Ceteris paribus

Other things being equal. Economists use this Latin phrase to cover their backs. For example, they might say that “higher interest rates will lead to lower inflation, ceteris paribus”, which means that they will stand by their prediction about inflation only if nothing else changes apart from the rise in the interest rate.

Charity

“Bah! Humbug”, was scrooge’s opinion of charitable giving. Some economists reckon charity goes against economic rationality. Some have argued that the popularity of charitable giving is proof that people are not economically rational. Others argue that it shows that altruism is something that people get pleasure (utility) from, and so are willing to spend some of their income on it. An interesting question is the extent to which the state is competing with private charity when it redistributes money from rich to poor or spends more on health care and whether this is inefficient.

Closed economy

An economy that does not take part in inter¬national trade; the opposite of an open economy. At the turn of the century about the only notable example left of a closed economy is North Korea.

Collateral

An asset pledged by a borrower that may be seized by a lender to recover the value of a loan if the borrower fails to meet the required interest charges or repayments.

Command economy

When a government controls all aspects of economic activity.

Commoditisation

The process of becoming a commodity. Micro¬chips, for example, started out as a specialized technical innovation, costing a lot and earning their makers a high profit on each chip. Now chips are largely homogeneous: the same chip can be used for many things, and any manufacturer willing to invest in some fairly standardized equipment can make them. As a result, competition is fierce and prices and profit margins are low. Some economists argue that in today's economy the faster pace of innovation will make the process of commoditization increasingly common.

Commodity

A comparatively homogeneous product that can typically be bought in bulk. It usually refers to a raw material – oil, cotton, cocoa, silver – but can also describe a manufactured product used to make other things, for example, microchips used in personal computers. Commodities are often traded on commodity exchanges. On average, the price of natural commodities has fallen steadily in real terms in defiance of some predictions that growing consumption of non-renewable such as copper would force prices up. At times the oil price has risen sharply in real terms, most notably during the 1970s, but this was due not to the exhaustion of limited supplies but to rationing by the OPEC cartel, or war, or fear of it, particularly in the oil-rich middle east.

Communism

The enemy of capitalism and now nearly extinct. Invented by Karl Marx, who predicted that feudalism and capitalism would be succeeded by the “dictatorship of the proletariat”, during which the state would “wither away” and economic life would be organized to achieve “from each according to his abilities, to each according to his needs”. The Soviet Union was the most prominent attempt to put communism into practice and the result was conspicuous failure, although some modern followers of Marx reckon that the soviets missed the point.

Competitive advantage

Something that gives a firm (or a person or a country) an edge over its rivals.

Competitiveness

“Real economists don’t talk about competitiveness,” said Paul Krugman, a much-respected contemporary economist. Real businessmen and real politicians talk about it all the time, however. Many firms have undergone savage downsizing to remain competitive, and governments have set up numerous committees to examine how to sharpen their countries’ economic performance.
Mr Krugman’s objection was not to the use of the term competitiveness by companies, which often do have competitors that they must beat, but to applying it to countries. At best, it is a meaningless word when applied to national economies; at worst, it encourages protectionism. Countries, he claimed, do not compete in the same way as companies. When two companies compete, one’s gain is the other’s loss, whereas international trade, Mr. Krugman argued, is not a zero-sum game: when two countries compete through trade they both win.
Yet measures of national competitiveness are not complete nonsense. A country’s future prosperity depends on its growth in productivity, which government policies can influence. Countries do compete in that they choose policies to promote higher living standards. Even so, conceptual and measurement difficulties mean that the growing number of indices purporting to compare the competitiveness of different countries should probably be taken with a large pinch of salt.

Complementary goods

When you buy a computer, you will also need to buy software. Computer hardware and software are therefore complementary goods: two products, for which an increase (or fall) in demand for one leads to an increase (fall) in demand for the other. Complements are the opposite of substitute goods. For instance, Microsoft Windows-based personal computers and apple Macs are substitutes.

Compound interest

If a deposit account of $100 earns an interest rate of 10% a year, then at the end of the year the account will contain $110. If all of that money is left in the account, then the 10% interest will be paid on the $110, so at the end of the second year $11 of interest will be added, making $121 in all. This is known as compound interest. By contrast, simple interest pays the 10% only on the original sum in the account.

Conditionality

When there are strings attached, for example, to international aid or loans from the IMF or World Bank. The delivery of the money may be made subject to the government of the country implementing economic or political reforms desired by the donor or lender.

Consumer confidence

How good consumers feel about their economic prospects. Measures of average consumer confidence can be a useful, though not infallible, indicators of how much consumers are likely to spend. Combined with measures such as business confidence, it can shed light on overall levels of economic activity.

Consumer prices

What people are usually thinking of when they worry about inflation. The prices paid by whoever finally consumes goods or services, as opposed to prices paid by firms at various stages of the production process.

Contestable market

A market in which an inefficient firm, or one earning excess profits, is likely to be driven out by a more efficient or less profitable rival. A market can be contestable even if it is dominated by a single firm, which appears to enjoy a monopoly with market power, and the new entrant exists only as potential competition.

Asymmetric information

When somebody knows more than somebody else. Such asymmetric information can make it difficult for the two people to do business together, which is why economists, especially those practicing game theory, are interested in it. Transactions involving asymmetric (or private) information are everywhere. A government selling broadcasting licenses does not know what buyers are prepared to pay for them; a lender does not know how likely a borrower is to repay; a used-car seller knows more about the quality of the car being sold than do potential buyers. This kind of asymmetry can distort people's incentives and result in significant inefficiencies.

Arbitrage

Buying an asset in one market and simultaneously selling an identical asset in another market at a higher price. Sometimes these will be identical assets in different markets, for instance, shares in a company listed on both the London stock exchange and New York stock exchange. Often the assets being arbitraged will be identical in a more complicated way, for example, they will be different sorts of financial securities that are each exposed to identical risks.
Some kinds of arbitrage are completely risk-free—this is pure arbitrage. For instance, if Euros are available more cheaply in dollars in London than in New York, Arbitrageurs (also known as Arbs) can make a risk-free profit by buying Euros in London and selling an identical amount of them in New York. Opportunities for pure arbitrage have become rare in recent years, partly because of the globalization of financial markets. Today, a lot of so called arbitrage, much of it done by hedge funds, involves assets that have some similarities but are not identical. This is not pure arbitrage and can be far from risk free.

Animal spirits

The colorful name that Keynes gave to one of the essential ingredients of economic prosperity: confidence. According to Keynes, animal spirits are a particular sort of confidence, "naive optimism". He meant this in the sense that, for entrepreneurs in particular, "the thought of ultimate loss which often overtakes pioneers, as experience undoubtedly tells us and them, is put aside as a healthy man puts aside the expectation of death". Where these animal spirits come from is something of a mystery. Certainly, attempts by politicians and others to talk up confidence by making optimistic noises about economic prospects have rarely done much good.

Bonds

"Gentlemen prefer bonds," punned Andrew Mellon, an American tycoon. A bond is an interest-bearing security issued by governments, companies and some other organizations. Bonds are an alternative way for the issuer to raise capital to selling shares or taking out a bank loan. Like shares in listed companies, once they have been issued bonds may be traded on the open market. A bond's yield is the interest rate (or coupon) paid on the bond divided by the bond's market price. Bonds are regarded as a lower risk investment. Government bonds, in particular, are highly unlikely to miss their promised payments. Corporate bonds issued by blue-chip "investment grade" companies are also unlikely to default; this might not be the case with high-yield "junk" bonds issued by firms with less healthy financials.

Budget

An annual procedure to decide how much public spending there should be in the year ahead and what mix of taxation, charging for services and borrowing should finance it. The budgeting process differs enormously from one country to another. In the United States, for example, the president proposes a budget in February for the fiscal year starting the following October, but this has to be approved by congress. By the time a final decision has to be made, ideally, no later than September, there are often three competing versions: the president's latest proposal, one from the senate and another from the House of Representatives. What finally emerges is the result of last-minute negotiations. Occasionally, delays in agreeing the budget have led to the temporary closure of some federal government offices. Contrast this with the UK, where most of what the government proposes is usually approved by parliament, and some changes take effect as soon as they are announced (subject to subsequent parliamentary vote).

Bubble

When the price of an asset rises far higher than can be explained by fundamentals, such as the income likely to derive from holding the asset. The Chicago tribune of April 13th 1890, writing about the then mania in real-estate prices, described "men who bought property at prices they knew perfectly well were fictitious, but who were prepared to pay such prices simply because they knew that some still greater fool could be depended on to take the property off their hands and leave them with a profit". Such behavior is a feature of all bubbles.
Famous bubbles include tulip mania in Holland during the 17th century, when the prices of tulip bulbs reached unheard of levels, and the south sea bubble in Britain a century later, although there have been many others since, including the dotcom bubble in internet company shares that burst in 2000. Economists argue about whether bubbles are the result of irrational crowd behavior (perhaps coupled with exploitation of the gullible masses by some savvy speculators) or, instead, are the result of rational decisions by people who have only limited information about the fundamental value of an asset and thus for whom it may be quite sensible to assume the market price is sound. Whatever their cause, bubbles do not last forever and often end not with a pop but with a crash.

Capital

Money or assets put to economic use, the life-blood of capitalism. Economists describe capital as one of the four essential ingredients of economic activity, the factors of production, along with land, labor and enterprise. Production processes that use a lot of capital relative to labour are capital intensive; those that use comparatively little capital are labour intensive. Capital takes different forms. A firm’s assets are known as its capital, which may include fixed capital (machinery, buildings, and so on) and working capital (stocks of raw materials and part-finished products, as well as money, which are used up quickly in the production process). Financial capital includes money, bonds and shares. Human capital is the economic wealth or potential contained in a person, some of it endowed at birth, the rest the product of training and education, if only in the university of life. The invisible glue of relationships and institutions that holds an economy together is its social capital.

Capital asset pricing model

A method of valuing assets and calculating the cost of capital (for an alternative, see arbitrage pricing theory). The capital asset pricing model (CAPM) has come to dominate modern finance.
The rationale of the CAPM can be simplified as follows. Investors can eliminate some sorts of risk, known as residual risk or alpha, by holding a diversified portfolio of assets (see modern portfolio theory). These alpha risks are specific to an individual asset, for example, the risk that a company’s managers will turn out to be no good. Some risks, such as that of a global recession, cannot be eliminated through diversification. So even a basket of all of the shares in a stock market will still be risky. People must be rewarded for investing in such a risky basket by earning returns on average above those that they can get on safer assets, such as treasury bills. Assuming investors diversify away alpha risks, how an investor values any particular asset should depend crucially on how much the asset’s price is affected by the risk of the market as a whole. The market’s risk contribution is captured by a measure of relative volatility, beta, which ¬indicates how much an asset’s price is expected to change when the overall market changes.
Safe investments have a beta close to zero: economists call these assets risk free. Riskier investments, such as a share, should earn a premium over the risk-free rate. How much is calculated by the average premium for all assets of that type, multiplied by the particular asset’s beta.
But does the CAPM work? It all comes down to beta, which some economists have found of dubious use. They think the CAPM may be an elegant theory that is no good in practice. Yet it is probably the best and certainly the most widely used method for calculating the cost of capital.

Capital controls

Government-imposed restrictions on the ability of capital to move in or out of a country. Examples include limits on foreign investment in a country’s financial markets, on direct investment by foreigners in businesses or property, and on domestic residents’ investments abroad. Until the 20th century capital controls were uncommon, but many countries then imposed them. Following the end of the Second World War only Switzerland, Canada and the United States adopted open capital regimes. Other rich countries maintained strict controls and many made them tougher during the 1960s and 1970s. This changed in the 1980s and early 1990s, when most developed countries scrapped their capital controls.
The pattern was more mixed in developing countries. Latin American countries imposed lots of them during the debt crisis of the 1980s then scrapped most of them from the late 1980s onwards. Asian countries began to loosen their widespread capital controls in the 1980s and did so more rapidly during the 1990s.
In developed countries, there were two main reasons why capital controls were lifted: free markets became more fashionable and financiers became adept at finding ways around the controls. Developing countries later discovered that foreign capital could play a part in financing domestic investment, from roads in Thailand to telecoms systems in Mexico, and, furthermore, that financial capital often brought with it valuable human capital. They also found that capital controls did not work and had unwanted side-effects. Latin America’s controls in the 1980s failed to keep much money at home and also deterred foreign investment.
The Asian economic crisis and capital flight of the late 1990s revived interest in capital controls, as some Asian governments wondered whether lifting the controls had left them vulnerable to the whims of international speculators, whose money could flow out of a country as fast as it once flowed in. There was also discussion of a “Tobin Tax” on short-term capital movements, proposed by James Tobin, a winner of the Nobel Prize for economics. Even so, they mostly considered only limited controls on short-term capital movements, particularly movements out of a country, and did not reverse the broader 20-year-old process of global financial and economic liberalization.

Capitalism

The winner, at least for now, of the battle of economic “isms”. Capitalism is a free-market system built on private ownership, in particular, the idea that owners of capital have property rights that entitle them to earn a profit as a reward for putting their capital at risk in some form of economic activity. Opinion (and practice) differs considerably among capitalist countries about what role the state should play in the economy. But everyone agrees that, at the very least, for capitalism to work the state must be strong enough to guarantee property rights. According to Karl Marx, capitalism contains the seeds of its own destruction, but so far this has proved a more accurate description of Marx’s progeny, communism.

Capital structure

The composition of a company’s mixture of debt and equity financing. A firm’s debt-equity ratio is often referred to as its gearing. Taking on more debt is known as gearing up, or increasing lever age. In the 1960s, Franco Modigliani and Merton miller (1923–2000) published a series of articles arguing that it did not matter whether a company financed its activities by issuing debt, or equity, or a mixture of the two. (For this they were awarded the Nobel Prize for economics.) But, they said, this rule does not apply if one source of financing is treated more favorably by the taxman than another. In the United States, debt has long had tax advantages over equity, so their theory implies that American firms should finance themselves with debt. Companies also finance themselves by using the profit they retain after paying dividends.

Cartel

An agreement among two or more firms in the same industry to co-operate in fixing prices and/or carving up the market and restricting the amount of output they produce. It is particularly common when there is an oligopoly. The aim of such collusion is to increase profit by reducing competition. Identifying and breaking up cartels is an important part of the competition policy overseen by antitrust watchdogs in most countries, although proving the existence of a cartel is rarely easy, as firms are usually not so careless as to put agreements to collude on paper. The desire to form cartels is strong. As Adam Smith put it, “people of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public or in some contrivance to raise prices.”

Catch-up effect

In any period, the economies of countries that start off poor generally grow faster than the economies of countries that start off rich. As a result, the national income of poor countries usually catches up with the national income of rich countries. New technology may even allow developing countries to leap-frog over industrialized countries with older technology. This, at least, is the traditional economic theory. In recent years, there has been considerable debate about the extent and speed of convergence in reality.
One reason to expect catch-up is that workers in poor countries have little access to capital, so their productivity is often low. Increasing the amount of capital at their disposal by only a small amount can produce huge gains in productivity. Countries with lots of capital, and as a result higher levels of productivity, would enjoy a much smaller gain from a similar increase in capital. This is one possible explanation for the much faster growth of Japan and Germany, compared with the United States and the UK, after the Second World War and the faster growth of several Asian “tigers”, compared with developed countries, during the 1980s and most of the 1990s.

Central bank

A guardian of the monetary system. A central bank sets short-term interest rates and oversees the health of the financial system, including by acting as lender of last resort to commercial banks that get into financial difficulties. The Federal Reserve, the central bank of the United States, was founded in 1913. The bank of England, known affectionately as the “old lady of thread Needle Street”, was established in 1694, 26 years after the creation of the world’s first central bank in Sweden. With the birth of the euro in 1999, the monetary policy powers of the central banks of 11 European countries were transferred to a new European central bank, based in Frankfurt.
During the 1990s there was a trend to make central banks independent from political intervention in their day-to-day operations and allow them to set interest rates. Independent central banks should be able to concentrate on the long-term needs of an economy, whereas political intervention may be guided by the short-term needs of the government. In theory, an independent central bank should reduce the risk of inflation. Some central banks are legally required to set interest rates so as to hit an explicit inflation target. Politicians are often tempted to exploit a possible short-term trade-off between inflation and unemployment, even though the long-term consequence of easing policy in this way is (most economists say) that the unemployment rate returns to what you started with and inflation is higher. An independent central bank, because it does not have to worry about persuading an electorate to vote for it, is more likely to act in the best long-run interests of the economy.

Chicago school

A fervently free-market economic philosophy long associated with the University of Chicago. At times, especially when Keynesian economics was the orthodoxy in much of the world, the Chicago school was regarded as a bastion of unworldly extremism. However, from the late 1970s it came to be regarded as mainstream by many and Chicago trained economists often played a crucial part in the implementation of policies of low inflation and market liberalization that swept the world during the 1980s and 1990s. By 2003, boasted the University of Chicago, some 22 of the 49 then winners of the Nobel Prize for economics had been faculty members, students or researchers there.

Classical economics

The dominant theory of economics from the 18th century to the 20th century, when it evolved into neo-classical economics. Classical economists, who included Adam Smith, David Ricardo and john Stuart Mill, believed that the pursuit of individual self-interest produced the greatest possible economic benefits for society as a whole through the power of the invisible hand. They also believed that an economy is always in equilibrium or moving towards it.
Equilibrium was ensured in the labor market by movements in wages and in the capital market by changes in the rate of interest. The interest rate ensured that total savings in an economy were equal to total investment. In disequilibrium, higher interest rates encouraged more saving and less investment, and lower rates meant less saving and more investment. When the demand for labor rose or fell, wages would also rise or fall to keep the workforce at full employment.
In the 1920s and 1930s, john Maynard Keynes attacked some of the main beliefs of classical and neo-classical economics, which became unfashionable. In particular, he argued that the rate of interest was determined or influenced by the speculative actions of investors in bonds and that wages were inflexible downwards, so that if demand for labor fell, the result would be higher unemployment rather than cheaper workers.

Contagion

The domino effect, such as when economic problems in one country spread to another.

Cost-benefit analysis

A method of reaching economic decisions by comparing the costs of doing something with its benefits. It sounds simple and common-sensical, but, in practice, it can easily become complicated and is much abused. With careful selection of the assumptions used in cost-benefit analysis it can be made to support, or oppose, almost anything. This is particularly so when the decision being con templated involves some cost or benefit for which there is no market price or which, because of an externality, is not fully reflected in the market price. Typical examples would be a project to build a hydroelectric dam in an area of outstanding natural beauty or a law to require factories to limit emissions of gases that may cause ill-health.

Credit

A loan extended or (sometimes) taken by, for example, delayed payment of an invoice.

Credit crunch

When banks suddenly stop lending, or bond market liquidity evaporates, usually because creditors have become extremely risk averse.

Creditor

A lender, whether by making a loan, buying a bond or allowing money owed now to be paid in the future.

Crony capitalism

An approach to business based on looking after yourself by looking out for your own. At least until the crisis of the late 1990s, some Asian companies, and even governments, were notable for awarding contracts only to family and friends. This was often a form of corruption, resulting in economic inefficiency.

Currency Peg

When a government announces that the exchange rate of its currency is fixed against another currency or currencies.

Default

Failure to fulfil the terms of a loan agreement. For example, a borrower is in default if he or she does not make scheduled interest payments on a loan or fails to pay off the loan at the agreed time. Judging the likelihood of default is a crucial part of pricing a loan. Interest rates are set so that, on average , a portfolio of loans will be profitable to the creditor , even if some individual loans are loss-making as a result of borrowers defaulting.

Deficit

In the red – when more money goes out than comes in. A budget deficit occurs when public spending exceeds government revenue. A current account deficit occurs when exports and inflows from private and official transfers are worth less than imports and transfer outflows.

Demand curve

A graph showing the relationship between the price of a good and the amount of demand for it at different prices.

Depreciation

A fall in the value of an asset or a currency; the opposite of appreciation.

Direct taxation

Taxes levied on the income or wealth of an individual or company. Contrast with indirect taxation. In much of the world, direct tax rates fell during the 1980s and 1990s, partly because some economists argued that high rates of tax on income discouraged people from working, and those high rates of tax on profit encouraged companies to move to countries with lower rates. Furthermore, high rates of income tax were viewed as politically unpopular. Even so, although rates were cut, because both personal income and corporate profits grew steadily throughout this period the total amount collected via direct taxation continued to rise. Economists often disagree about which of direct taxes or indirect taxes are the least inefficient method of taxation.

Discount rate

The rate of interest charged by a central bank when lending to other financial institutions. It also refers to a rate of interest used when calculating discounted cash flow.

Disequilibrium

When supply and demand in a market are not in balance. Contrast with equilibrium.

Disinflation

A fall in the rate of inflation. This means a slower increase in prices but not a fall in prices, which is known as deflation.

Econometrics

Mathematics and sophisticated computing applied to economics. Econometricians crunch data in search of economic relationships that have statistical significance. Sometimes this is done to test a theory; at other times the computers churn the numbers until they come up with an interesting result. Some economists are fierce critics of theory-free econometrics.

Economic man

At the heart of economic theory is homo Economicus, the economist’s model of human behavior. In traditional classical economics and in neo-classical economics it was assumed that people acted in their own self-interest. Adam smith argued that society was made better off by everybody pursuing their selfish interests through the workings of the invisible hand. However, in recent years, mainstream economists have tried to include a broader range of human motivations in their models. There have been attempts to model altruism and charity. Behavioral economics has drawn on psychological insights into human behavior to explain economic phenomena.

Efficiency wages

Wages that are set at above the market clearing rate so as to encourage workers to increase their productivity.

Economies of scale

Bigger is better. In many industries, as output increases, the average cost of each unit produced falls. One reason is that overheads and other fixed costs can be spread over more units of output. However, getting bigger can also increase average costs (diseconomies of scale) because it is more difficult to manage a big operation, for instance.

Economics

The “dismal science”, according to Thomas Carlyle, a 19th-century Scottish writer. It has been described in many ways, few of them flattering. The most concise, non-abusive, definition is the study of how society uses its scarce resources.

Enterprise

One of the factors of production, along with land, labour and capital. The creative juices of capitalism; the animal spirits of the entrepreneur.

Entrepreneur

The life and soul of the capitalist party. Somebody who has the idea and enterprise to mix together the other factors of production to produce something valuable. An entrepreneur must be willing to take a risk in pursuit of a profit.

Equilibrium

When supply and demand are in balance. At the equilibrium price, the quantity that buyers are willing to buy exactly matches the quantity that sellers are willing to sell. So everybody is satisfied, unlike when there is disequilibrium. In classical economics, it is assumed that markets always tend towards equilibrium and return to it in the event that something causes a temporary disequilibrium. General equilibrium is when supply and demand are balanced simultaneously in all the markets in an economy. Keynes questioned whether the economy always moved to equilibrium, for instance, to ensure full employment.

Euro

The main currency of the European Union, launched in January 1999 and in general circulation since 2002.

Euro zone

The economy comprising all the countries that have adopted the euro. There is much debate among economists about whether the euro zone is in fact an optimal currency area.

Eurodollar

A deposit in dollars held in a bank outside the United States. Such deposits are often set up to avoid taxes and currency exchange costs. They are frequently lent out and have become an important method of credit creation.

European central bank

The central bank of the European union, responsible since January 1999 for setting the official short-term interest rate in countries using the euro as their domestic currency. In this role, the European central bank (ECB) replaced national central banks such as Germany’s Bundesbank, which became local branches of the ECB.

Evolutionary economics

A Darwinian approach to economics, sometimes called institutional economics. Following the tradition of Schumpeter, it views the economy as an evolving system and places a strong emphasis on dynamics, changing structures (including technologies, institutions, beliefs and behavior) and disequilibrium processes (such as innovation, selection and imitation).

Exchange controls

Limits on the amount of foreign currency that can be taken into a country, or of domestic currency that can be taken abroad.

Exogenous

Outside the model. For instance, in traditional neo-classical economics, models of growth rely on an exogenous factor. To keep growing, an economy needs continual infusions of technological progress. Yet this is a force that the neo-classical model makes no attempt to explain. The rate of technological progress comes from outside the model; it is simply assumed by the economic modelers. In other words, it is exogenous. New growth theory tries to calculate the rate of technological progress inside the economic model by mapping its relationship to factors such as human capital, free markets, competition and government expenditure. Thus, in these models, growth is ¬endogenous.

Expected returns

The capital gain plus income that investors think they will earn by making an investment, at the time they invest.

Exports

Sales abroad. Exports grew steadily as a share of world output during the second half of the 20th century. Yet by some measures this share was no higher than at the end of the 19th century, before free trade fell victim to a political backlash.

Factor cost

A measure of output reflecting the costs of the factors of production used, rather than market prices, which may differ because of indirect tax and subsidy.

Fair trade

Many politicians and NGOs argue that free trade is not enough; it should also be fair. On the face of it, fairness is self-evidently a good thing. However, fairness, in trade as in beauty, lies in the eye of the beholder. Frederic Bastiat, a 19th-century French satirist, once observed that the sun offered unfair competition to candle makers. If windows could be boarded up during the day, he argued, more jobs could be created making candles. American trade unions complain that Mexicans’ lower wages, say, give them an unfair advantage. Mexicans say they cannot compete fairly against more productive American counterparts. Both sides are wrong. Mexicans are paid less than Americans largely because they are, in general, less productive. There is nothing unfair about that; indeed, it helps to make trade mutually beneficial. The mutual benefits of trade also disprove the fair traders' other complaint, that free trade harms poor countries.

Consumer surplus

The difference between what a consumer would be willing to pay for a good or service and what that consumer actually has to pay. Added to producer surplus, it provides a measure of the total economic benefit of a sale.

Consumption

What consumers do? Within an economy, this can be broken down into private and public consumption (see public spending). The more resources a society consumes, the less it has to save or invest, although, paradoxically, higher consumption may encourage higher investment. The life-cycle hypothesis suggests that at certain stages of life individuals are more likely to be saving than consuming, and at other stages they are more likely to be heavy consumers. Some economists argue that consumption taxes are a more efficient form of taxation than taxes on wealth, capital, property or income.

Corruption

Being corrupt is not just bad for the soul, it also harms the economy. Research has found that in countries with a lot of corruption, less of their gdp goes into investment and they have lower growth rates. Corrupt countries invest less in education, a sector of the economy that pays big economic dividends but small bribes, than do clean countries, thereby reducing their human capital. They also attract less foreign direct investment.
There is no such thing as good corruption, but some sorts of corruption are less bad than others. Some economists point to similarities between bribery and paying taxes or buying a licence to operate. Where it is predictable – where the briber knows what to pay and can be sure of getting what it pays for--corruption harms the economy far less than where it is capricious.
The absence of corruption has huge economic benefits, however, by allowing the development of institutions that enable a market economy to function efficiently. In many of the world’s more corrupt countries, the distinction between private interest and public duty is still unfamiliar. Countries that have made graft the exception rather than the rule in the conduct of public affairs have been helped to grow by the emergence of institutions such as an independent judiciary, a free press, a well-paid civil service and, perhaps crucially, an economy in which firms have to compete for customers and capital.

Cost of capital

The amount a firm must pay the owners of capital for the privilege of using it. This includes interest payments on corporate debt, as well as the dividends generated for shareholders. In deciding whether to proceed with a project, firms should calculate whether the project is likely to generate sufficient revenue to cover all the costs incurred, including the cost of capital. Calculating the cost of equity capital can be tricky.

Credit creation

Making loans. Often the amount of credit creation is subject to regulation. Lenders may have limits on the amount of loans they can make relative to the assets they have, so that they run little risk of bankruptcy. A central bank tries to keep the amount of credit creation below the level at which it would increase the money supply so much that inflation accelerates. This was never easy to get right even when most lending was by banks, but it has become much harder with the recent growth of non-bank lending, such as by credit-card com¬panies and retailers. Missing text

Crowding out

When the state does something it may discourage, or crowd out, private-sector attempts to do the same thing. At times, excessive government borrowing has been blamed for low private-sector borrowing and, consequently, low investment and (because the economic returns on public borrowing are typically lower than those on private debt, especially corporate debt) slower economic growth. This has become less of a concern in recent years as government indebtedness has declined and, because of globalization, firms have become more able to raise capital outside their home country. Crowding out may also come from state spending on things that might be provided more efficiently by the private sector, such as health care, or even through charity, redistribution.

Currency board

A means by which some countries try to defend their currency from speculative attack. A country that introduces a currency board commits itself to converting its domestic currency on demand at a fixed exchange rate. To make this commitment credible, the currency board holds reserves of foreign currency (or gold or some other liquid asset) equal at the fixed rate of exchange to at least 100% of the value of the domestic currency that is issued.
Unlike a conventional central bank, which can print money at will, a currency board can issue domestic notes and coins only when there are enough foreign exchange reserves to back it. Under a strict currency board regime, interest rates adjust automatically. If investors want to switch out of domestic currency into, say, us dollars, then the supply of domestic currency will automatically shrink. This will cause domestic interest rates to rise, until eventually it becomes attractive for investors to hold local currency again.
Like any fixed exchange rate system, a currency board offers the prospect of a stable exchange rate and its strict discipline also brings benefits that ordinary exchange rate pegs lack. Profligate governments, for instance, cannot use the central bank’s printing presses to fund large deficits. Hence currency boards are more credible than fixed exchange rates. The downside is that, like other fixed exchange rate systems, currency boards prevent governments from setting their own interest rates.
If local inflation remains higher than that of the country to which the currency is pegged, the currencies of countries with currency boards can become overvalued and uncompetitive. Governments cannot use the exchange rate to help the economy adjust to an outside shock, such as a fall in export prices or sharp shifts in capital flows. Instead, domestic wages and prices must adjust, which may not happen for many years, if ever.
A currency board can also put pressure on banks and other financial institutions if interest rates rise sharply as investors dump local currency. For emerging markets with fragile banking systems, this can be a dangerous drawback. Furthermore, a classic currency board, unlike a central bank, cannot act as a lender of last resort. A conventional central bank can stem a potential banking panic by lending money freely to banks that are feeling the pinch. A classic currency board cannot, although in practice some currency boards have more freedom than the classic description implies. The danger is that if they use this freedom, governments may cause currency speculators and others to doubt the government’s commitment to living within the strict disciplines imposed by the currency board.
Argentina's decision to devalue the peso amid economic and political crisis in january 2002, a decade after it adopted a currency board, showed that adopting a currency board is neither a panacea nor a guarantee that an exchange rate backed by one will remain fixed come what may.

Deadweight cost/loss

The extent to which the value and impact of a tax, tax relief or subsidy is reduced because of its side-effects. For instance, increasing the amount of tax levied on workers’ pay will lead some workers to stop working or work less, so reducing the amount of extra tax to be collected. However, creating a tax relief or subsidy to encourage people to buy life insurance would have a deadweight cost because people who would have bought insurance anyway would benefit.

Debt

“Neither a borrower nor a lender be,” wrote Shakespeare in “hamlet”. Actually, the availability of debt, and the willingness to take it on, is a crucial ingredient of economic growth, because it allows individuals, firms and governments to make investments they would not otherwise be able to afford. The price of debt is interest. Until recently, lending was an activity dominated by banks (although mortgages for individuals buying their homes have long been available from special housing savings institutions). Since the 1960s, debt has become increasingly available from other sources. Companies have sold trillions of dollars worth of bonds to investors in the financial markets. Individuals have been able to borrow with credit cards, and for those who have nowhere else to turn there are pawn shops and loan sharks, which charge very high rates of interest. Total private-sector debt in 2003 was around 150% of GDP in the United States, compared with less than 100% in 1928. In most countries, by far the biggest single borrower is the state, through the national debt.

Debt forgiveness

Cancelling or rescheduling a borrower’s debts to lessen the pain of the debt burden. Debt forgiveness is increasingly viewed as the best way to relieve the financial problems facing poorer countries. Some of these countries have to pay so much in interest each year to foreign lenders that they have little money left to spend on the long-term solutions to their poverty, such as educating their workers and building a modern infrastructure. In 1998 the world bank calculated that around 40 of the world’s poorest countries had an “unsustainably high” debt burden: the present value of their total debts was more than 220% of their exports.
Debt forgiveness has potential drawbacks. For instance, there is a risk of moral hazard. If countries that borrow too much are let off their financial obligations, poor countries may feel they have nothing to lose by borrowing as much as they can. This is why policymakers often argue that debt forgiveness should come with a conditionality clause, for instance, a requirement that countries have a track record of implementing economic reforms designed to prevent a repeat of the errors that first created the need for debt forgiveness. This is the approach taken by the World Bank’s HIPC (highly indebted poor country) initiative, launched in 1996 and expanded in 1999. However, by 2003, only eight of the 38 poor countries eligible under the program had made enough progress in reform to have some debt forgiven.

Deflation

Since 1930 it has been the norm in most developed countries for average prices to rise year after year. However, before 1930 deflation (falling prices) was as likely as inflation. On the eve of the First World War, for example, prices in the UK, overall, were almost exactly the same as they had been at the time of the great fire of London in 1666.
Deflation is a persistent fall in the general price level of goods and services. It is not to be confused with a decline in prices in one economic sector or with a fall in the inflation rate (which is known as disinflation).
Sometimes deflation can be harmless, perhaps even a good thing, if lower prices lift real income and hence spending power. In the last 30 years of the 19th century, for example, consumer prices fell by almost half in the United States, as the expansion of railways and advances in industrial technology brought cheaper ways to make everything. Yet annual real GDP growth over the period averaged more than 4%.
Deflation is dangerous, however, more so even than inflation, when it reflects a sharp slump in demand, excess capacity and a shrinking money supply, as in the great depression of the early 1930s. In the four years to 1933, American consumer prices fell by 25% and real GDP by 30%. Runaway deflation of this sort can be much more damaging than runaway inflation, because it creates a vicious spiral that is hard to escape. The expectation that prices will be lower tomorrow may encourage consumers to delay purchases, depressing demand and forcing firms to cut prices by even more. Falling prices also inflate the real burden of debt (that is, increase real interest rates) causing bankruptcy and bank failure. This makes deflation particularly dangerous for economies that have large amounts of corporate debt. Most serious of all, deflation can make monetary policy ineffective: nominal interest rates cannot be negative, so real rates can get stuck too high.

Demand

One of the two words economists uses most; the other is supply. These are the twin driving forces of the market economy. Demand is not just about measuring what people want; for economists, it refers to the amount of a good or service that people are both willing and able to buy. The demand curve measures the relationship between the price of a good and the amount of it demanded. Usually, as the price rises, fewer people are willing and able to buy it; in other words, demand falls. When demand changes, economists explain this in one of two ways. A movement along the demand curve occurs when a price change alters the quantity demanded; but if the price were to go back to where it was before, so would the amount demanded. A shift in the demand curve occurs when the amount demanded would be different from what it was previously at any chosen price, for example, if there is no change in the market price, but demand rises or falls. The slope of the demand curve indicates the elasticity of demand. For approaches to modeling demand see revealed preference.
Policymakers seek to manipulate aggregate demand to keep the economy growing as fast as is possible without pushing up inflation. Keynesians try to manage demand through fiscal policy; monetarists prefer to use the money supply. Neither approach has been especially successful in practice, particularly when attempting to manage short-term demand through fine tuning.

Deregulation

Cutting red tape. The process of removing legal or quasi-legal restrictions on the amount of competition, the sorts of business done, or the prices charged within a particular industry. During the last two decades of the 20th century, many governments committed to the free market pursued policies of liberalization based on substantial amounts of deregulation hand-in-hand with the privatization of industries owned by the state. The aim was to decrease the role of government in the economy and to increase competition. Even so, red tape is alive and well. In the United States, with some 60 federal agencies issuing more than 1,800 rules a year, in 1998 the code of federal regulations was more than 130,000 pages thick. However, not all regulation is necessarily bad. According to estimates by the American office of management and budget, the annual cost of these rules was $289 billion, but the annual benefits were $298 billion.

Devaluation

A sudden fall in the value of a currency against other currencies. Strictly, devaluation refers only to sharp falls in a currency within a fixed exchange rate system. Also it usually refers to a deliberate act of government policy, although in recent years reluctant devalues have blamed financial speculation. Most studies of devaluation suggest that its beneficial effects on competitiveness are only temporary; over time they are eroded by higher prices .

Derivatives

Financial assets that “derive” their value from other assets. For example, an option to buy a share is derived from the share. Some politicians and others responsible for financial regulation blame the growing use of derivatives for increasing volatility in asset prices, and for being a source of danger to their users. Economists mostly regard derivatives as a good thing, allowing more precise pricing of financial risk and better risk management. However, they concede that when derivatives are misused the leverage that is often an integral part of them can have devastating consequences. So they come with an economists’ health warning: if you don’t understand it, don’t use it.
The world of derivatives is riddled with jargon. Here are translations of the most important bits.
• a forward contract commits the user to buying or selling an asset at a specific price on a specific date in the future.
• a future is a forward contract that is traded on an exchange.
• a swap is a contract by which two parties exchange the cashflow linked to a liability or an asset. For example, two companies, one with a loan on a fixed interest rate over ten years and the other with a similar loan on a floating interest rate over the same period, may agree to take over each other’s obligations, so that the first pays the floating rate and the second the fixed rate.
• an option is a contract that gives the buyer the right, but not the obligation, to sell or buy a particular asset at a particular price, on or before a specified date.
• an over-the-counter is a derivative that is not traded on an exchange but is purchased from, say, an investment bank.
• exotics are derivatives that are complex or are available in emerging economies.
• plain-vanilla derivatives, in contrast to exotics, are typically exchange-traded, relate to developed economies and are comparatively uncomplicated.

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

Disintermediation

Cutting out the middleman. Disintermediation has become a buzz word in financial services in particular, as competitive and technological changes have done away with the need for established intermediaries. Banks have seen much of their business slip away, such as lending to companies that now tap capital markets direct. New economy ¬theorists argued that many retailers would be disintermediated as the internet enabled customers to transact directly with producers without needing to visit a shop. But this has happened more slowly than they predicted.

Diversification

Not putting all your eggs in one basket. Investors are encouraged to do this by modern portfolio theory, as holding several different shares and other assets helps to reduce risk. At the sharp end of business, however, diversification is somewhat out of fashion. Economic studies of diversifying corporate mergers have found that these often hurt the shareholders of the acquiring firm; by contrast, diversified firms that have sold off non-core businesses have typically made their shareholders much better off.

Division of labor

People are better off specializing than trying to be jacks of all trades and ending up masters of none. The logic of dividing the workforce into different crafts and professions is the same as that underpinning the case for free trade: everybody benefits from doing those things in which they have a comparative advantage and using income from doing so to meet their other needs.

Dollarization

When a country’s own money is replaced as its citizens’ preferred currency by the us dollar. This can be a deliberate government policy or the result of many private choices by buyers and sellers (for instance, at the first sign of trouble, investors across Latin America generally flee into dollars). When it is government policy, dollarization is, in essence, a beefed up currency board.
The appeal of dollarization is that the value of the dollar is more stable than the distrusted local currency, which may well have a history of suddenly falling in value. By eliminating all possible risk of devaluation against the dollar, the cost of local companies’ and the government’s borrowing in international markets is reduced, as the currency risk is removed. A big downside is that the country hands over control of monetary policy to the federal reserve, and the right interest rate for the united states may not be appropriate for the dollarized country, if that country and the united states do not constitute an optimal currency area. This is one reason that in some countries the local currency has been displaced by another fairly stable currency, such as, in some central European economies, the euro (and before that the d-mark).

Economic and monetary union

In January 1999, 11 of the 15 countries in the European Union merged their national currencies into a single European currency, the euro. This decision was motivated partly by politics and partly by hoped-for economic benefits from the creation of a single, integrated European economy. These benefits included currency stability and low inflation, underwritten by an independent European central bank (a particular boon for countries with poor inflation records, such as Italy and Spain, but less so for traditionally low-inflation Germany). Furthermore, European businesses and individuals stood to save from handling one currency rather than many. Comparing prices and wages across the euro zone became easier, increasing competition by making it easier for companies to sell throughout the euro-zone and for consumers to shop around.
Forming the single currency also involved big risks, however. Euro members gave up both the right to set their own interest rates and the option of moving exchange rates against each other. They also agreed to limit their budget deficits under a stability and growth pact. Some economists argued that this loss of flexibility could prove costly if their economies did not behave as one and could not easily adjust in other ways. How well the euro-zone functions will depend on how closely it resembles what economists call an optimal currency area. When the euro economies are not growing in unison, a common monetary policy risks being too loose for some and too tight for others. If so, there may need to be large transfers of funds from regions doing well to those doing badly. But if the effects of shocks persist, fiscal transfers would merely delay the day of reckoning; ultimately, wages or people (or both) would have to shift.
In its first few years, the euro fell sharply against the dollar, though it recovered during late 2002. Sluggish growth in some European economies led to intense pressure for interest rate cuts, and to the stability and growth pact being breached, though not scrapped. Even so, by 2003 12 countries had adopted the euro, with the expectation of more to follow after the enlargement of the EU to 25 members in 2004.

Economic indicator

A statistic used for judging the health of an economy, such as GDP per head, the rate of unemployment or the rate of inflation. Such statistics are often subject to huge revisions in the months and years after they are first published, thus causing difficulties and embarrassment for the economic policymakers who rely on them.

Economic sanctions

A way of punishing errant countries, which is currently more acceptable than bombing or invading them. One or more restrictions are imposed on international trade with the targeted country in order to persuade the target’s government to change a policy. Possible sanctions include limiting export or import trade with the target; constraining investment in the target; and preventing transfers of money involving citizens or the government of the target. Sanctions can be multi¬lateral, with many countries acting together, perhaps under the auspices of the United Nations, or unilateral, when one country takes action on its own.
How effective sanctions are is debatable. According to one study, between 1914 and 1990 there were 116 occasions on which various countries imposed economic sanctions. Two-thirds of these failed to achieve their stated goals. The cost to the country imposing sanctions can be large, particularly when it is acting unilaterally. It is estimated that in 1995 imposing sanctions on other countries cost the American economy over $15 billion in lost exports and 200,000 in lost jobs in export industries.
Widely considered a notable success was the use of economic sanctions against the apartheid regime in South Africa, although some economists question how big a part the sanctions actually played. Clearly important was the fact that the sanctions were imposed multilaterally by the international community, so there were comparatively few breaches of the restrictions. But, arguably, the most crucial factor in persuading the government in Pretoria to cave in was that foreign companies fearing that their share price would fall because their investments in South Africa would attract bad publicity voluntarily chose for commercial reasons to disinvest.

Efficient market hypothesis

You can’t beat the market. The efficient market hypothesis says that the price of a financial asset reflects all the information available and responds only to unexpected news. Thus prices can be regarded as optimal estimates of true investment value at all times. It is impossible for investors to predict whether the price will move up or down (future price movements are likely to follow a random walk), so on average an investor is unlikely to beat the market. This belief underpins ¬arbitrage pricing theory, the capital asset pricing model and concepts such as beta.
The hypothesis had few critics among financial economists during the 1960s and 1970s, but it has come under increasing attack since then. The fact that financial prices were far more volatile than appeared to be justified by new information, and that financial bubbles sometimes formed, led economists to question the theory. Behavioural economics has challenged one of the main sources of market efficiency, the idea that all investors are fully rational homo economicus. Some economists have noted the fact that information gathering is a costly process, so it is unlikely that all available information will be reflected in prices. Others have pointed to the fact that arbitrage can become more costly, and thus less likely, the further away from fundamentals prices move. The efficient market hypothesis is now one of the most controversial and well-studied propositions in economics, although no consensus has been reached on which markets, if any, are efficient. However, even if the ideal does not exist, the efficient market hypothesis is useful in judging the relative efficiency of one market compared with another.

Elasticity

A measure of the responsiveness of one variable to changes in another. Economists have identified four main types.
• price elasticity measures how much the quantity of supply of a good, or demand for it, changes if its price changes. If the percentage change in quantity is more than the percentage change in price, the good is price elastic; if it is less, the good is inelastic.
• income elasticity of demand measures how the quantity demanded changes when income increases.
• cross-elasticity shows how the demand for one good (say, coffee) changes when the price of another good (say, tea) changes. If they are substitute goods (tea and coffee) the cross-elasticity will be positive: an increase in the price of tea will increase demand for coffee. If they are complementary goods (tea and teapots) the cross-elasticity will be negative. If they are unrelated (tea and oil) the cross-elasticity will be zero.
• elasticity of substitution describes how easily one input in the production process, such as labour, can be substituted for another, such as machinery.

Engel's law

People generally spend a smaller share of their budget on food as their income rises. Ernst Engel, a Russian statistician, first made this observation in 1857. The reason is that food is a necessity, which poor people have to buy. As people get richer they can afford better-quality food, so their food spending may increase, but they can also afford luxuries beyond the budgets of poor people. Hence the share of food in total spending falls as incomes grow.

Enron

In a word, all that was wrong with American capitalism at the start of the 21st century. Until late 2001, Enron, an energy company turned financial powerhouse based in Houston, Texas, had been one of the most admired firms in the United States and the world. It was praised for everything from pioneering energy trading via the internet to its innovative Corporatate culture and its system of employment evaluation by peer review, which resulted in those that were not rated by their peers being fired. However, revelations of accounting fraud by the firm led to its bankruptcy, prompting what was widely described as a crisis of confidence in American capitalism. This, as well as further scandals involving accounting fraud (WorldCom) and other dubious practices (many by wall street firms), resulted in efforts to reform corporate governance, the legal liability of company bosses, accounting, wall street research and regulation.

Equity risk premium

The extra reward investors get for buying a share over what they get for holding a less risky asset, such as a government bond. Modern financial theory assumes that the premium will be just big enough on average to compensate the investor for the extra risk. However, studies have found that the average equity premium over many years has been much larger than appears to be justified by the average riskiness of shares. To solve this so-called equity premium puzzle, some economists have suggested that investors may have greater risk aversion towards shares than traditional theory assumes. Some claim that the past equity premium was mismeasured, or reflected an unrepresentative sample of share prices. Others suggest that the high premium is evidence that the efficient market hypothesis does not apply to the stock market. Some economists think that the premium fell to more easily explained levels during the 1990s. Nobody really knows which, if any, of these interpretations is right.

Excess returns

Getting more money from an economic investment than you needed to justify investing. In perfect competition, the factors of production earn only normal returns, that is, the minimum amount of wages, profit, interest or rent needed to secure their use in the economic activity in question, rather than in an alternative. Excess returns can only be earned for more than a short period when there is market failure, especially monopoly, because otherwise the existence of excess returns would quickly attract competition, which would drive down returns until they were normal.

Expectations

What people assume about the future, especially when they make decisions. Economists debate whether people have irrational or rational expectations, or adaptive expectations that change to reflect learning from past mistakes.

Expenditure tax

A tax on what people spend, rather than what they earn or their wealth. Economists often regard it as more efficient than other taxes because it may discourage productive economic activity less; it is not the creating of income and wealth that is taxed, but the spending of it. It can be a form of indirect taxation, added to the price of a good or service when it is sold, or direct taxation, levied on people’s income minus their savings over a year.

Factors of production

The ingredients of economic activity: land, labor, capital and enterprise.

Factory prices

The prices charged by producers to wholesalers and retailers. Because these prices are eventually passed on to the end customer, changes in factory prices, also known as producer prices, can be a leading indicator of consumer price inflation.

Federal Reserve System

America's Central Bank. Set up in 1913, and popularly known as the fed, the system divides the United States into 12 Federal Reserve districts, each with its own regional federal reserve bank. These are overseen by the Federal Reserve board, consisting of seven governors based in Washington, dc. Monetary policy is decided by its federal open market committee.

Financial centre

A place in which an above-average amount of financial business takes place. The big ones are New York, London, Tokyo and Frankfurt. Small ones such as Dublin, Bermuda, Luxembourg and the Cayman islands also play an important part in the global financial system. Globalization and the increase in electronic trading has raised concerns about whether there will be as much need for financial centres in the 21st century as there was in the 19th and 20th centuries. So far, the evidence suggests that the biggest, at least, will remain important.

Financial instrument

Certificate of ownership of a financial asset, such as a bond or a share.

Financial intermediary

A middleman. An individual or institution that brings together investors (the source of funds) and users of funds (such as borrowers). May be increasingly at risk of disintermediation.

Fine tuning

A favorite government policy in the Keynesian-dominated 1950s and 1960s, involving frequent adjustments to fiscal policy and/or monetary policy to alter the level of demand to keep the economy growing at a steady rate. The trouble was and is, partly because of the inadequacies of economic forecasting, that these frequent adjustments were and are often mistaken, making the economy's growth path more, rather than less, erratic. In the 1990s, fine tuning was increasingly shunned by central banks and governments, which stopped trying to manage short-term demand and instead aimed to pursue long-term macroeconomic goals, which required fewer adjustments to policy. Or so they claimed. In practice, there continued to be some attempted fine tuning.

First-mover advantage

The early bird gets the worm. Game theory shows that being the first to enter a market or to introduce an innovation can be a huge advantage, not just because the first firm in can erect barriers to entry, but also because potential rivals may be discouraged from committing the resources necessary to compete successfully. However, this advantage may sometimes be cancelled out by the benefits enjoyed by followers, such as the chance to avoid--and learn from--the mistakes made by the first mover.

Fiscal drag

A nice little earner for the state. Fiscal drag is the tendency of revenue from taxation to rise as a share of GDP in a growing economy. Tax allowances, progressive tax rates and the threshold above which a particular rate of tax applies usually remain constant or are changed only gradually. By contrast, when the economy grows, income, spending and corporate profit rise. So the tax-take increases too, without any need for government action. This helps slow the rate of increase in demand, reducing the pace of growth, making it less likely to result in higher inflation. Thus fiscal drag is an automatic stabilizer, as it acts naturally to keep demand stable.

Fiscal neutrality

When the net effect of taxation and public spending is neutral, neither stimulating nor dampening demand. The term can be used to describe the overall stance of fiscal policy: a balanced budget is neutral, as total tax revenue equals total public spending. It can also refer more narrowly to the combined impact of new measures introduced in an annual budget: the budget can be fiscally neutral if any new taxes equal any new spending, even if the overall stance of the budget either boosts or slows demand.

Fixed costs

Production costs that do not change when the quantity of output produced changes, for instance, the cost of renting an office or factory space. Contrast with variable costs.

Flotation

Going public. When shares in a company are sold to the public for the first time through an initial public offering. The number of shares sold by the original private investors is called the "float". Also, when a bond issue is sold in the financial markets.

Forecasting

Best guesses about the future. Despite complex economic theories and cutting-edge econometrics, the forecasts economists make are often badly wrong. Indeed, following economic forecasts has been likened to driving a car blindfolded, following directions given by a person who is looking out of the back window. Some of the inaccuracies in forecasts reflect badly designed models; often, the problem is that the future actually is unpredictable. Maybe it would be better to take the advice of Sam Goldwyn, a movie mogul, "never prophesy, especially about the future."

Free Riding

Getting the benefit of a good or service without paying for it, not necessarily illegally. This may be possible because certain types of goods and services are actually hard to charge for--a firework display, for instance. Another way to look at this may be that the good or service has a positive externality. However, there can sometimes be a free-rider problem, if the number of people willing to pay for the good or service is not enough to cover the cost of providing it. In this case, the good or service might not be produced, even though it would be beneficial for the economy as a whole to have it. Public goods are often at risk of free riding; in their case, the problem can be overcome by financing the good by imposing a tax on the entire population.

Frictional unemployment

That part of the jobless total caused by people simply changing jobs and taking their time about it, because they are spending time on job search or are taking a break before starting with a new employer. There is likely to be some frictional unemployment even when there is technically full employment, because most people change jobs from time to time.

Gearing

A company's debt expressed as a percentage of its equity; also known as leverage.

General agreement on tariffs and trade

Or GAAT, the vehicle for promoting international free trade, through a series of rounds of negotiations between the governments of trading countries. The first GAAT round began in 1945. The last led to the establishment of the world trade organization in 1995.

Gilts

Shorthand for gilt-edged securities, meaning a safe bet, at least as far as receiving interest and avoiding default goes. The price of gilts can vary considerably over time, however, creating a degree of risk for investors. Usually the term is applied only to government bonds.

Global public goods

Public goods that cannot be provided by one country acting alone but only by the joint efforts of many (strictly, all) countries. Some economists, along with global institutions such as the UN, reckon that such goods include international law and law enforcement, a stable global financial system, an open trading system, health, peace and environmental sustainability.

Government expenditure

Spending by national and local government and some government-backed institutions.