Will someone explain the economy to me?

Factual Questions
1

I feel like a real idiot, because I read the Times every day and am pretty well informed. But one thing confuses the bejeebers out of me. For the last few days, Tom Brokaw has told us how delighted Alan Greenspan is that the economy’s slowing down and unemployment is rising. It has something to do with interest rates (is it good when those go up or down? I never borrow money!).

Please talk to me like I am a backwards five-year-old and explain why low unemployment and a booming economy make Alan Greenspan so danged unhappy?

2

Eve, I think the thing that scares Greenspan the most is INFLATION! All his policies seem to be designed to keep inflation in check, regardless of what else might be going on.

People having too much money (booming economy, low unemployment) makes them careless about how much things cost. Sellers raise their profit margins by raising their prices and people don’t stop buying, like they are supposed to, because they have a lot of money. Prices go up, so wages go up, etc., etc. – an INFLATIONARY SPIRAL!

I share your disbelief that strong economic growth is a bad thing. That’s why it’s “strong”, right? But AFAIK, that’s why Mr. Greenspan is in a bad mood when everyone else is happy.

Unrelated p.s.: I finished Platinum Girl yesterday. Great book, but my dad is tired of me telling him interesting facts about Jean Harlow. Wait till I bend his ear about Theda Bara!

3

OK, I’m going to try to make this quick with what I remember from high school.

Inflation: Joe-Bob buys a lottery ticket and wins $100. He takes this to the Bank of Bob and opens a savings account. Jimmy-Bob wants to rebuild his porch. Amazingly enough, this will cost him $100. He goes to the Bank of Bob and asks to borrow $100. They will give this two him for 2% (yeah right). Jimmy-Bob takes this money and buys the materials needed for his porch.

The problem is, where does that $100 come from. If Joe-Bob needs his money back, they’ll still give it to him. So, where did this money come from? Essentially, they made it.

Suddenly, Joe-Bob realizes he needs that $100 back to buy a new lawn mower. He goes back to the bank to get his $100 back. Thye give him the money and now there’s more money out in the economy. This is inflation.

Given, it’s an overly-simplified explanation of inflation, but you get the idea. Now, inflation is controlled partly by raising interest rates. Let’s say Jimmy-Bob wants that loan, but it’s going to cost him 12% instead of 2%. He is more likely to decide that the porch isn’t that important and wait for rates to come down. This slows down and stabilizes the economy. On the other hand, it’s dangerous to get too slow, at which point interest rates start to drop.

It’s impossible to really hit the perfect equilibrium of low interest, high interest, etc., so the economy ebs and flows as the Fed tries to keep it as steady as possible. As simple as I’ve tried to make this, I’m not sure if it makes total sense. Hope it help anyway.

4

Well, Eve, imagine the economy as the engine to a car.

If the engine runs too slow, or not at all, that’s not good.

But if the engine runs too fast, it overheats and sometimes explodes, which is definitely not good.

If the economy expands too fast, it overheats, reflected by inflation. Businesses begin chasing after very limited supplies of goods and services (remember reading all the talk about how much money kids with computer degrees were making just after getting out of school) and end up paying much more than usual because so many other people are looking to buy those same services or hire those same people.

And when businesses pay more money for the same stuff they’ve always been buying (or hiring), they try to pass as much of those extra costs as they can on to the consumer. Thus, prices in many industries rise. And as those prices rise, they make other prices rise, either because the goods they buy are getting more expensive; or because their employees demand more money to buy goods that are getting more expensive. End result- inflation.

Generally, unemployment and inflation are inversely related- that is, as unemployment rises, inflation goes down (business can cut costs in employee salaries and staffing, and so can charge less for their product); and as unemployment decreases, inflation goes up (for the reasons outlined above). The 1980 economy was an aberration in having both high unemployment and high inflation (a result of a recession for the unemployment, combined with a massive jack in oil prices for the inflation); likewise, much of the late '90’s economy has been an aberration in having both low unemployment and low inflation.

Greenspan’s big worry is that at some point, the bad effects of the economy will start catching up to the good effects, with the result of either a jump in unemployment (back to a normal 7%), a jump in inflation, or a massive stock crash and Depression. So he’s been trying to keep the economy from pushing full forward by hiking interest rates.

Now that unemployment is starting to rise, it looks like the worst dangers of a sudden drop and crash are over, and Greenspan can stop putting all of his effort into keeping the economy from exploding.
Disclaimer- that’s just what I’ve been able to surmise from several college Economics classes and occasional reading of the paper. But as Harry Truman once said, “If you laid all the economists in the world end to end, they’d point in all directions.”

5

You see, all your similes about cars exploding and hillbillies building porches only confuse poor little me all the more. This is why I did so badly in math class.

I understand that inflation is bad, but isn’t employment and higher wages GOOD? I know I’m happy when I’m working and making money . . . So what if prices rise? I’ve got money!

[Pluto, you’re a doll! Glad you liked Jean!]

6

OK, go back to the last economic turndown.

At its bottom, there were a lot (note careful use of qualitative terminlogy) of people in bread lines, and a lot of empty offices, idle machinery, etc. (“unused capacity”). So, as the economy improved, the previously jobless could be employed for little more than the cost of pulling dust covers off things.

Now, all of that unused capacity is, eventually, used. Then, when people are to be employed, office buildings must be erected, machines must be built, and so on. Much more expensive. The faster the economy grows, the sooner that that point is reached.

“Inflation” is the quality of monetary momentum (mass of money times velocity of money) increasing relative to the actual amount of goods available. To have the wherewithal to create new stuff (office buildings, machinery, etc.), one traditionally goes to the banks, borrows money, creates the stuff, utilizes (rents, sells) it, and pays back the bank. During the lifetime of the loan, there’s a greater mass of money, and the goods to back it with aren’t created until after (sometimes well after) the loan is taken out. Thus, inflation; the faster the economy grows, the higher.

(This, of course, is the extremely simplified version. All sorts of things can cause the inflation not to show up until later. And, of course, the less-simplified version includes government deficit spending, fractional reserve policies, fiat currency v. specie, and yadda yadda).

Now, generally speaking, inflation is good for debtors, but bad for creditors (and anyone with a bank account is a creditor). Also, if and when the economic boom slows or even stops, just as the appearance of inflation can be delayed, so can its disappearance. We experienced this phenomenon under that Carter fellow, back in the late '70s (you may have heard of him from your parents), although the real cause was largely the extremely bogus government policies followed in the '60s and early '70s and Carter, like Hoover, got the blame for what he didn’t cause (although Carter was a lot more snooty about it that Hoover was). Ever since, the powers-that-be have had the feces scared out of them by the specter of inflation, and more so of stagflation (i.e.,, inflation combined with a static or declining economy).

Since there’s no particularly good reason for the economy to grow at a torrid pace (most Americans have evidently decided that they’re rich enough, more or less, and the population isn’t growing that fast), Greenspan and his cronies would like it act sedately.

7

It’s a problem of INDIVIDUAL, SHORT TERM good versus NATIONAL, LONG TERM good. While it is good for YOU to have a job with lots of money, if EVERYONE has a job with lots of money, suddenly, your money isn’t worth as much, since everyone has the same amount. Voila, inflation.

Wealth is largely relative. If most families make about $50,000 a year, and we suddenly give everyone in the country a million dollars a year, that million dollars would have the purchasing power of what $50,000 used to, and no one would be ANY richer. That’s inflation.

Thus, while it may SUCK for you to be unemployed, it is necessary to keep everyone else doing well. Or at least, that’s what classic theory tells us. The late 1990’s have showed us otherwise. Then again, the late 1920’s supposedly showed us otherwise too, and we all know what THAT led too…

8

Not everyone agrees with Greenspans theory, which boils down to “Prosperity brings recession”. Which to some of us, is like saying “if you’re in good health, that’s a sure sign you are going to get sick”. Many liberals, conservatives, moderates, libertarians, etc., disagree with Greenspans theory. While many with those same leanings agree with him 100%! I think it will be at least 15 years before we can look back and know if he was right of crazy.

9

Well, now I know a little more about some aspects, and am even MORE confused about others . . .

10

Yes, you’ve got more money, and that’s good. But the workers at McDonald’s don’t have nearly as much more money, and so inflation to them is bad. And eventually, it gets so bad that they go out and do all sorts of destructive things like riot and protest and vote Democratic, all of which are very bad for the economy.

I think I just channeled P.J. O’Rourke. Cool.

Anyways. The best way to think of it is that there tends to be a balance between unemployment and inflation. Unemployment is high, inflation is low. Inflation is high, unemployment is low.

Over the last few years, we’ve had a bonanza of both low inflation and low unemployment. This means either:

A) Nothing, as one of them will catch up to the other (eventually unemployment will go back up, or inflation will go back up)
B) Nothing, as we have finally broken out of the old mold for markets, and we’ll never be affected by business cycles (recession, recovery, growth, boom, then bust back to recession) again
or C) Absolute disaster.

Option B isn’t particularly realistic, as much as the newspapers want to bandy about the idea; they’ve said the same thing during every boom since World War II, and every boom eventually busted.

Option C is based on this:

Economics is math up to the point where people want to make decisions, and then it gets all fouled up by psychology. If we could perfectly predict how people would act- or people acted with perfect rationality- then economics would be a true science. And libertarian and communist governments would actually work, so you can see how much of a pipe dream that is. (Sorry; still channelling P.J.)

To illustrate- A McDonald’s Extra Value Meal costs me $4.50, and is a three mile drive from work. A Burger King Meal costs me $5.50 and is a ten mile drive from work. Mathematically, and logically, I should always go to McDonald’s. Except that I just heard an ad for Burger King, and was thinking about how tired I’m getting of McDonald’s food, and it’s a nice day for a drive, so the distance doesn’t matter, and so I go off for a meal that isn’t a smart decision (just ask my arteries) because I just feel like it.

So what Greenspan is worried about is “irrational exuberance.” That is, that people are throwing their money at the stock market and putting themselves in massive debt because times seem so sunny that we think we’ll never again have to worry about a rainy day. And Greenspan believes that rainy days will come again, and is worried (as am I, I must admit), that once the first rainy day comes, most Americans will panic. “Aaaaah!” they’ll scream, “My IPO just lost $5 a share! I can’t afford my new Range Rover! I need to sell all of my stock before I lose even more money!” Whereupon other investors scream “Aaaaah! Everyone’s selling off their stocks! It’s another Great Depression! We’ll need to sell off all of our stocks before anyone else so that we don’t go completely bankrupt!” And thus, even though the original news wasn’t too bad, all of the fears and frights build up on each other into a nervous breakdown of the Stock Exchange.
Thankfully, the recent increase in unemployment means that were much more likely to be heading into option A- that the bad effects of the economy are slowly starting to catch up to us rather than hitting us all at once like a mugger in a dark alley (and with the same effects, pocketbook-wise).
Basically, as far as most economists are concerned- Low inflation is good. Low unemployment is good. But you can’t have both of them at the same time for a while without facing massive, nasty rebounds in one, the other, or both.
Any better?

11

“Greenspan believes that rainy days will come again, and is worried (as am I, I must admit), that once the first rainy day comes, most Americans will panic.”

–So why is Alan Greenspan so happy when he sees the clouds rolling in, and is even out there doing rain dances?

12

Ah, weather. What a wonderful analogy for economics. Incredibly complicated, indescribably difficult to predict, unnerveingly chaotic, truly understood by no one, fodder for the weekend paper and backyard prognosticator, and amazingly simple to figure out after the fact.

Do yourself a favor - forget about terms like ‘booming economy,’ ‘expanding economy,’ ‘slowing down the economy,’ ‘heating up the economy,’ and their ilk. They do great for newscasters looking to fit things into a ten second sound bite, and maybe even economists using them in a specific manner, but in general do little more than confuse the layman. It would be like describing the weather as ‘good beach weather’ by using only a few factors -say, temperature, humidity and wind speed. Yes, in many ways one could get a fair idea of what the day is like, but there is a lot left out of the picture.

So many nails have been hit on the head by many of the above posters that I’ll let their explanations (of how inflation is caused and why it is bad, for example) sink in for a while. Just don’t think of Greenspan trying to pee on the parade - think of him as having (very) limited control over the economy, with (very) imperfect and (very) incomplete information. But he does the best he can, and he is responsible for more of the economy than a journalist is. In a way, it would be like people, seeing the sun shining and proclaiming it a ‘great day.’ Greenspan the weatherman gets nervous when this happens too often, because he knows that drought conditions or fire hazards will likely follow too many of these ‘great days’ in a row. So, though surfers are upset that he pushes the ‘clouds’ button to stem off such a possibility, he is doing it to keep a balance. Oh yeah, weather analogies, like weather predictions, are seldom perfect.

One of his chief goals, (a goal he is arguably overfixated upon) is keeping inflation at bay. He does not see lots of happy people working at new and exciting jobs - he sees indicators that more money is flowing into the economy than could be accounted for without dramatic inflation. He knows that people with and without those jobs will suffer greatly if inflation gets out of hand. He knows (actually, I should be saying ‘he believes’) that by putting off a bit of some people’s happiness now, he is protecting a lot more people’s happiness in the long run. One tool at his disposal (remember, these are imperfect tools) is raising interest rates. By doing that, he is trying to make sure the economy maintains itself without dramatic instances of inflation.

So ignore the ‘booming economy’ gibberish. Think of it as ‘hey, one aspect of the economy is that is lots of people have jobs and are pushing up the cost of Big Macs making it harder for poor people to afford them and harder for businesses to hire new people (who demand high salaries to pay for expensive Big Macs) and pretty soon if this keeps up people won’t be able to afford McNothing at their current salary so wages will have to go up even more though this won’t help them very much because Big Macs have gotten so expensive that McNothing looks tasty.’ (whew… gotta take a breath after that sentence.)

Hope that helps a bit. Now I’m hungry. But not angry. Anything else I’m -gry?
Rhythmdvl

13

“low unemployment” That one is easy. If there are fewer people available to work, companies have to pay more for them, then they have to charge more for their products. uck.
“booming economy” Well, he talks about this but it’s not in my area. Frankly, I don’t have much of a clue what it refers to either. This is mid-california & one shopping center has 11 vacancies of 16 store fronts & another one about 5 in twenty storefronts. The US OPen didn’t do squat for that.

14

The question, like most, is not “is inflation good or bad?” but “for whom is it good and for whom is it bad?”.

The short answer is that inflation is bad for people who have lots of money, and good for people who have little more than they earn from wages.

Consider two example cases: a wealthy widow whose assets are invested in income producing securities, and a guy who owns little more than a mortgage on a house and a car. As wages and prices rise, the guy with the house and car doesn’t worry much, since his wages go up more or less in synch with the prices he pays. He’s no better or worse off on that score. And since real estate generally appreciates, particularly in an inflationary period, the value of his property is increasing, while the amount he pays for it steadily declines in relation to other prices (assuming he has a fixed mortgage) – we all know of people who found themselves paying what seemed ridiculously small mortgage payments in the eighties and nineties after the preceding inflationary periods.

Meanwhile, the widow has a certain amount of cash that’s worth, in terms of purchasing power, a bit less every day. In a long period of steady inflation, the value of that money can be reduced far more rapidly than it is being increased by investment income. The value of her investments in stocks is not likely to keep pace with inflation, since the business entities they represent are being beset with higher costs for employees (wages), for the materials and services they require (prices), and for the money they need to expand (interest rates) making it more difficult for the businesses to maintain or increase their profits. Any investments in bonds will be returning their fixed interest rates – likely far less than the rate of inflation. The longer the inflationary period lasts, the closer she comes to being completely cleaned out. She’ll still nominally have the same amount of money, it just won’t be good for much anymore.

Lest we conclude from this that, since we more closely resemble the working stiff than the wealthy widow, inflation is a good thing, consider that a ready supply of money for investment in business expansion and in real estate purchases is essential to the long term health of the economy; if the widow’s money gets wiped out by the steady degradation of its value, the banks won’t have it to lend to the businesses, which will wither on the vine, ultimately taking the working stiff’s job with them when they fail.

To a certain extent, Greenspan’s attitude is simply them what has watching out for the interests of other thems what has. But without that them what has goes on having, the rest of us ain’t gonna get either.

Credit where credit’s due department: the explanation above and to a degree the examples borrow heavily from William Greider’s book on the Federal Reserve system, Secrets of the Temple: How the Federal Reserve Runs the Country. The book’s dated (it was published in 1989) and is probably too conventionally liberal even for me anymore, but when I read it years ago I finally began to dimly understand some of how all this money stuff works.

15

I like the analogy that the economy is like the weather. Some people want it to rain more (farmers) while other want it to rain less (golfers).

Greenspan generally holds to the theory that inflation shoud be between 0-3% and unemployment should be between 4-7%. Other persons not currenly in power at the fed think inflation should be 4-7% and unemployment should be 0-3%.

There is some point where infation is to high or to low, and there is also a point at which unemployment is to high or to low. Where these point are is open to debate.

side note-
Inflation/unemployment rates/interest rates have been a point of contention since the dawn of the industrial economy. At the turn of the centry national political was high focused on these subjects. Most working people and unions supported “free silver” code words of the day for more infation, while most capital (owners and bosses) wanted less inflation or “anti-free silver.” A very intersting book on this subject is “Big Trouble” about the turn of the centry mine workers riots in which the ex-governor of idaho was assinated.

michael

16

I came across a syndicated columnist who seems to answer your question. I have no idea whether this guy is particularly savvy or not, but anyone who quotes Joseph Schumpeter can’t be all bad:

http://www.jewishworldreview.com/cols/kudlow.html