Common Cents Read online

  There are two main threads that orient the presentation. First and foremost, is a focus on fundamental economics. For generations, students were told that economics is the study of supply and demand. Yes, supply is what we produce and demand is what we consume, and where they meet is the equilibrium price that insures we produce all we consume and vice-versa. Economics is also characterized as the science of making trade-offs in a world of scarce and finite resources. Both of these definitions are useful to our understanding of the workings of economics, but I offer another, more prosaic, addendum to that definition: Economics is the fine art of managing change through exchange.

  Supply, demand, and budget trade-offs are often studied through static economic analysis, while the world we live in is dynamic. Static analysis is like a photograph that captures a single moment in time. We can draw supply and demand curves on a graph and see the immediate relationships and measure their magnitude. Dynamic analysis is like a movie with scenes, characters, and plots that constantly change. We must follow the story through time in order to fully understand it. Our world is constantly changing and this change is a fundamental concept of macroeconomics.

  By nature, all living organisms must adapt to change in order to survive. In adapting to survive, humans have learned to work together, much like other social animals. We’ve banded together in communities and developed a highly differentiated division of labor. We use exchange markets to efficiently manage our risks while maximizing our welfare. In so doing, we are forced to make choices from among an almost infinite array of options: Should I go to medical school or law school? Should I become a banker or an actor? Should I buy a house or rent? Live in New York or Oklahoma? Buy a Prius or a Porsche? Should I marry this person or that? Do it now or later? Many of these choices are constrained because they are either mutually exclusive or they exceed the limits of our budgets. So we prioritize, weigh the trade-offs, and commit to our fates. We cannot avoid facing such choices: if we want economic security in old age, there are actions we will all need to take before we get there. The strategy is fairly straightforward: we continually advance toward our life objectives while staying flexible in case outside events force us to change our path.

  When we add up these choices, trade-offs, and exchanges among millions of individuals we have the essential makings of a market economy. As we study and analyze these activities we can develop a framework for understanding how everything does, or doesn’t, work. The best our economic theories can do is to make sure we are making the right choices given our goals. I hope the essence of this process can be described most simply as that fine art of managing change through exchange.

  The second thread that runs through this guide is its focus on actual policies and their outcomes, an analysis that encompasses economics, finance, and politics. Our policy discussions will rely on both a theoretical understanding based on applied economics, and an empirical approach that attempts to evaluate recent events. The Great Recession is primarily a financial phenomenon that severely impacted the real economy and the political arena, so we will apply our economic thinking in a practical sense to these various problems that challenge us.

  I use a simple visual concept to help orient the “big picture” relationship between economics and politics. Economics is like a box with rigid sides that act as constraints. Politics is our latitude to make different social choices as long as they respect the boundary constraints of the box. In other words, politics will determine how we allocate resources in society, but economics will determine how many or few resources we will have to distribute. Our policies should seek to loosen our economic constraints by expanding the sides of the box so we have more resources with which to achieve our social goals.

  For this guide to be effective it should be short, simple and, I hope, perfectly comprehensible to the average high school student. The rudimentary approach is deliberate; one must understand how to carve a block of stone in all its dimensions and qualities before one builds a cathedral. And we must be familiar with the conventional before we can explore the unconventional. Thus, my chosen methods may appear overly simplistic at times, but the purpose is to challenge the logic of a very complex edifice. Understanding macroeconomic relationships requires a certain concentration of mind and careful study. As much as I would like, I cannot spoon-feed all the relevant knowledge in a guide so brief, so I confess this simplified guide will still challenge the thoughtful mind (it’s longer than I had hoped and still grows like kudzu). I have attached asterisks to different sections of the guide to indicate the difficulty factor. Like a hot meter on an Indian or Mexican food menu, * designates the material as easy, ** as moderate, and *** as challenging.

  I will not be introducing lots of statistics, graphs, or mathematical concepts, as I believe these can overly complicate the fundamental understanding of political economy and scare off the mathematically timid. Such data and formulations are easily discovered on the Internet these days and I provide links where appropriate. In order to keep the narrative flowing, many terms and arcane concepts are explained with expanded footnotes and links to the glossary and Wikipedia. My purpose here is to appeal to reason, common sense, and logic, not to scholarly erudition. Many seemingly obvious issues will be investigated at more profound levels of meaning that trained economists often take for granted (and sometimes get wrong). For example: What is capital? What is money? What determines the value of money? How is wealth produced? How is it distributed? Why do we have business cycles? How can hedge funds make billions of dollars and yet produce nothing? And what the heck is QE2 if not a cruise ship?

  Please be advised that what you read here is the beginning of a public and personal journey, hopefully down the right road to your desired destination.

  Revisions

  This 2nd edition of A Citizen’s Survival Guide adds an Appendix D with links to the most popular blog posts on Casino Capitalism and Crapshoot Politics, connecting some of the theoretical ideas presented in the book to current events.

  Aside from the usual correction of typos, cleaning up language, and some new anecdotes, the main revision (previously making this 2.0 rather than 1.1) is to the sections on monetary policy under a fiat currency regime. The previous analysis adopted the traditional framework of a convertible currency, such as the dollar backed by gold. This type of currency regime no longer exists because we live in a world of floating, government-fiat currencies. This means that the government, operating through the agencies of the Federal Reserve Bank and the U.S. Treasury, is able to issue new currency at will, without having to tax, borrow, or commandeer gold from the citizenry. What this does is relax the debt constraints that apply to a fixed currency regime. So, neither the debt ceiling nor the absolute level of national debt or the deficit really constrain monetary and fiscal policy. Of course, this means that the burden of the national debt is borne by the entire economy and is reflected in the exchange value of the dollar. The is still a kind of a tax on people who own dollar assets, or most Americans (as well as foreign holders of U.S. debt), it is just not a direct tax that requires payment on April 15, but a tax that can slowly erode the value of dollar assets. The key statistic that indicates the degree of worry is the debt as a percentage of GDP, which measures the ability of the economy to service this debt without serious negative consequences.

  For a more thorough, and somewhat complex, investigation of the fiat currency framework, I would advise reading up on Modern Monetary Theory, or MMT. A brief explanation is offered in the Glossary with a link to Wikipedia.

  This version also includes an Executive Summary.

  Executive Summary

  · Time, uncertainty, and risk: Our physical and social worlds pass through time, introducing change, uncertainty, and risk. These are the concepts that inform our study of economics, finance, and politics.

  · Consumption/acquisitiveness is the traditional foundation of classical economic theory. However, we need to incorporate uncertainty into our contextual framewor
k and loss aversion into our behavioral assumptions in order to comprehend macro phenomena.

  · Loss aversion is at the root of political demands for social insurance entitlements and government intervention into the economy.

  · Sustainable growth is the primary objective of economic policy. Long-term labor productivity and capital accumulation are the sources of real wealth.

  · Sustainability and stability through time is a function of individual and systemic adaptability to change.

  · The input/output flows of the economy are distributional problems that need to balance consumption, production, and investment through time.

  · Monetary phenomena cannot substitute for real phenomena. The role of the term structure of interest rates is crucial to managing the balance required for long-term market stability and economic sustainability.

  · Financial markets are inherently unstable because asset price movements promote herd behavior. This herd behavior becomes more threatening to the system with excessive debt and credit financing relative to equity.

  · The main policy challenges we face are

  1. Transparent Federal Reserve policy that targets the stable value of the currency and the financial integrity of the banking system.

  2. Entitlement reform to manage risk through a combination of self-insurance, private insurance markets, and social insurance, in that order of priority.

  3. Tax reform that balances budgetary requirements across different sources of tax revenue by function: consumption, production, and wealth. Tax policy should align economic growth with private capital accumulation and productivity.

  4. Agency failures in all institutional settings must be managed with transparency, open competition, and accountability, combined with regulatory statutes and oversight.

  5. Skewed distributions of resources, especially income and financial wealth that can best be mitigated by understanding the mechanisms of the market and the interaction with policy.

  6. A more responsive democratic political process by controlling the agency problems in government through electoral competition, transparency, and accountability.

  Introduction

  I have subtitled this book deliberately as a guide to the economy, but with the essential roles of politics and financial markets integrated to show how these specific spheres of our modern world interact to shape the whole. This approach is a deliberate return to past traditions of scholarship. Before the early to mid-20th century, intellectuals who studied the social sciences called themselves political economists or historians. Adam Smith, David Ricardo, Karl Marx, Joseph Schumpeter, Friedrich Hayek, and John Maynard Keynes all studied the world in an integral manner. It was only when social science progressed technically and became highly specialized that we divided its various disciplines into separate schools of knowledge. We pay a price for the efficiency gains of specialization when we crowd out comprehensive knowledge. By the late 20th century, when I was studying at the academy, the common joke was that a sociologist was a failed historian, a historian a failed political scientist, a political scientist a failed economist, an economist a failed mathematician, and a mathematician a failed physicist. The progression leads towards more and more technically complex disciplines, suggesting if one isn't smart enough to study physics, perhaps a step back to sociology is a more viable career choice. (Apologies here to sociologists – it's only a joke.) To complete this circle to its logical conclusion, a physicist is merely a failed philosopher, wherein technical proficiency has reached its final disutility in understanding the meaning of existence.

  I started my career in economics in the 1970s. The profession has changed drastically in the past forty years, becoming more and more focused on mathematical precision. (I confess I have not kept pace with the math.) But the world we study has also changed in important ways. With the breakdown in the early 1970s of the Bretton Woods system that governed international trade relations and currency exchange, the sheer volume of trade in international capital and foreign exchange markets has exploded, dwarfing the real goods markets.[3] This expansion of international finance has been facilitated by the revolution in information and communications. The result is that the tail of finance is wagging the dog of international trade and commerce. Finance theory and the study of international capital markets have become critical to understanding macroeconomics and to formulating policy. Today, no economist can understand the capitalist world economy without a solid grounding in finance and capital markets.

  To compound our difficulties, the political evolution of democracy and freedom has led to more transparency and greater participation in electoral politics and policymaking. So, while the international economy has become more closely linked with international capital flows, the role of national and international politics has exerted greater influence in determining policy choices and outcomes. This is a good thing, but through this democratization we have learned how futile economic theorizing can be without factoring in the political process.

  We also have the difficulty of predicting human behavior, which is the most basic building block in the study of the social sciences. The complex mathematical models of macroeconomic analysis are based on simplistic and convenient assumptions about behavior that do not necessarily hold under real world conditions. Consequently, these models’ veracity has become highly suspect (more on this shortly). The sad tale of our recent financial debacle shows that many of our top economists do not understand how financial markets work, our political leaders and government regulators do not understand economics, and most scary of all, our financial experts in the banking industry do not seem to understand their own mathematical risk models!

  There is another joke often repeated in intellectual circles: a specialist studies a subject in such focus and depth that soon he or she come to know everything about nothing, while a generalist is so overwhelmed by the breadth of knowledge that soon he or she ends up knowing nothing about everything. We need a good balance between these two extremes. Unfortunately, we have far too few deep, well-balanced generalists. One, because the sheer volume of knowledge they must integrate is immense, and two, because our market society overwhelmingly favors the division of labor and rewards the expert/specialist. This is apparent in both the university and the marketplace. We suffer the consequences most deeply at the pinnacle of leadership. Our recent leadership failures suggest that comprehensive policymaking belongs to the realm of the wise and experienced multi-disciplined generalist, not to the specialist.

  Another point I would like to reiterate in this introduction is that economics and its related disciplines are founded on simple common sense. The esoteric jargon bantered about is sometimes necessary for preciseness of meaning and shorthand communication between professionals, but beneath the big words and theories lie the most rudimentary and intuitively obvious concepts. (Jargon makes experts feel and sound more important, to justify the high fees they hope to earn for their musings.) Sweep away the jargon and these basic, intuitive, economic concepts lend themselves to a variety of more concrete analogies and metaphors. If you suspect wealth is really created by hard work, saving, and prudent investing, rather than by the interest rate manipulations of the Federal Reserve, you're on the right track. (Perhaps we should send a few copies of Poor Richard's Almanac to Washington?)

  A final point: in addition to finance and economics, I will offer a brief overview of democratic politics, specifically American politics. I have been researching presidential voting patterns—and that ubiquitous red-blue political divide—since 2000. The misperceptions perpetuated across the land regarding such divisions have become an impediment to our democratic governing process. If we can't govern as a pluralistic democracy of diverse and varied groups, then this talk about policy becomes superfluous and we will deserve what we end up with. Most ordinary people understand this intuitively and reject the rank partisanship that divides our politics. But politics is emotional and sometimes we lose our grip on reason, which is why our gra
ndmothers told us to avoid discussing politics (and religion) altogether in polite social circles. However, we can take heart. The scientist in me knows that we have ways of testing beliefs empirically and this factual evidence can and must be weighed against pure faith-based ideology.

  By the end of this guide I hope to have framed some of the most pressing political and economic issues that confound our society. We need to understand our recent financial meltdown in its historical context, which goes back at least two generations. We need to understand our future in terms of government entitlement programs and clearly define the public vs. private sphere of responsibility. We need to be able to understand the trade-offs between taxing and spending and how to sustain the stable improvement in our standard of living and quality of life. We need to understand how to order our society so that we can achieve the lives we choose and also preserve our freedoms. We must pay careful attention to such issues as education, healthcare, old age insurance, inequality, and the environment. But first we must have a framework of understanding to help us make the decisions that will best address these many challenges.

  The complexity of our society often appears like a gigantic jigsaw puzzle, its pieces strewn about on the ground. Our task is to put the pieces of the puzzle in their proper place in order to see the big picture and the complete solution. There's nothing a jigsaw puzzle demands more than patience and persistence.

  I will present a foundation of simple related concepts upon which we can build a model that simplifies our tasks. Economists love models (the kinds of models architects use to design buildings, not the ones we fantasize about during a Victoria's Secret television special). Models are mental constructs that help us focus on, and manipulate, the most fundamental pieces of the puzzle, so that we are not distracted by thousands of less important elements. Think of how we solve a jigsaw puzzle—we look for edge pieces to frame out the puzzle and then group together similar color shades such as sky or water. Then we try to find the pieces that link these larger elements together, the whole time using the completed picture on the cover box to guide us.