Models are constructed of building blocks, one laid upon the other until the edifice we previously conceived only in our imaginations is realized in full. There are two basic building blocks on which our analysis rests, and which I cannot emphasize enough. The first is the idea that all economic decisions can be reduced to the simple choice of whether to consume now or at some future time. This will be explained more fully in the next chapter. We’ll see that this is the most fundamental economic choice we must make each day. It drives everything else in economic analysis. When we discuss issues like interest rates, or saving, or investing or producing, the analysis can be reduced to how it affects that simple decision to consume now or later.
The second building block relates to the most basic human instinct that influences our choices and preferences. This instinct has often been referred to as risk aversion, but is more accurately defined as loss aversion. Loss aversion flows from a survival instinct that makes us most sensitive to perceptions of risk. Behavioral studies and experiments have shown how human subjects are much more conscious of threats of loss than they are to possible gains.[4] This has profound implications for how we respond to a changing world. As you proceed through the economic analyses that follow, keep in mind these two behavioral foundations of our model: consume now or later and avoid loss.
In the following chapter we will construct a simple economic model. Once we have this as a solid reference point, we will then add some complexity to it, but without losing our conceptual understanding. Ultimately, we will have a solid framework for analyzing the more detailed questions addressed in subsequent chapters.
In Chapter Two I will address some of the problems of macroeconomics (the top-down analysis of the economy as a whole, which includes unemployment and inflation) as opposed to microeconomics (the bottom-up analysis of households, businesses, and markets). Most non-economists are unaware that reconciling the concrete theories of microeconomics with macroeconomics has been a serious challenge for economists, one that still remains unresolved and a work-in-progress. We know how to maximize revenues and minimize costs for businesses. We're less confident when it comes to managing the entire economy with the tools of monetary policy (interest rates) and fiscal policy (taxes and government spending). (As if you needed reminding!) This is why we observe so much expert controversy over what to do with policy: should we increase the stimulus, cut taxes, or balance the budget? Raise interest rates or lower them? Take a ride on QE3? (See Quantitative Easing.)
One reason for the failures of economics, finance and related policies resides in the assumptions we make about how people behave under varying conditions of uncertainty and change. We need to improve upon the mechanical conceptualization of homo economicus on which economic theory is based. This conceptualization refers to the notion that businesses, or firms, always maximize profits and individuals always maximize utility (when was the last time you woke up and figured how to maximize your utility that day?); that decision makers are well informed (we know all we need to know to make correct choices); and that individuals’ and firms’ preferences are fixed over time and homogeneous (or uniform) across actors (we all want basically the same thing all the time). Though these simplified notions of behavior have been very useful for building powerful and sophisticated mathematical models of markets, they fail painfully in describing many social phenomena. In this vein, I will address in some depth two keystones to developing our macroeconomic understanding: the concepts of capital and risk. How these interact with actual human behavior to shape our capitalist system will clear up a lot of common confusion.
Chapter Three addresses the fundamentals of democratic politics in the United States, from the electoral system to the organization of parties to the functioning of government. Most of us are aware that our politics are teetering on the brink of dysfunction. Unless we can make democracy work, all talk of formulating sound economic policy becomes rather superfluous. We can only briefly cover political issues, but a basic discussion is necessary in order to move on to the final two chapters. In Chapter Four we retrace some background history to the present financial and economic crisis and outline the basic principles to help orient our policy agenda.
As the preceding chapters set up the necessary tools we need to understand the dynamics of our political economy, the last, Chapter Five, becomes the meat and potatoes. We are now ready to apply our model to the most pressing policy issues going forward. These include Federal Reserve policy, entitlement reform, tax policy, and the issue of regulation, also called the principal-agent problem.
I will not address such issues as defense spending, national security, the effects of terrorism, or immigration policy. I hope this does not disappoint, but these issues depend heavily on non-economic considerations and on geopolitical issues that would require a much longer and differently focused book.
I end this guide with a recommended reading list that covers the material discussed in greater depth. For easy reference, I have also included a glossary of economic and financial terms. Many of the terms will link to Wikipedia for more focused and in-depth treatment. This book is not encyclopedic, rather it is integrative, which I believe makes it a more valuable guide.
Lastly, I welcome comments, suggestions, and/or corrections from readers. Some of the ideas presented here are controversial and open to further evaluation and interpretation. The point of participatory democracy is not necessarily to agree, but to engage. I don’t presume to have all the answers, so constructive criticism or enlightened disagreement is always appreciated. These can be submitted by commenting on the discussion board at the “Casino Capitalism and Crapshoot Politics” blog or directly to the author by email:
http://casinocap.wordpress.com/
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Ideas are no longer cast in stone by the permanence of paper publishing and the immutable “book.” As digital publishing and distribution allow frequent updates, this guide will be a living document, a work-in-progress that will periodically adapt to changes and corrections (readers can refer to version numbers). Updated e-books in your digital library can be downloaded again and again without cost from Amazon, Apple, or other distributors. I sincerely hope discussions with readers will continue to improve the presentation and clarity of the ideas discussed. Please do weigh in and help correct my errors.
Chapter One
A Simple Model
We begin our journey by constructing a rudimentary economic model that, like a vehicle, will help us navigate our analysis. Economists can’t help themselves from building logical models to illustrate and order their thought processes. Whether simple or complex, these models can be extremely useful tools as they offer necessary touchstones when the analysis gets highly abstract. For our purposes we will stick to five basic building blocks for our model. Before discussing, I will list them here first. I also include the dimension of time[5] with the contextual variable of uncertainty that factors into all economic decision-making.
1. The decision of when and how much to consume, which has implications for savings and investment = consume now or later;
2. The opportunity to trade (or exchange) goods and services with others;
3. The role of money in facilitating these exchanges across time and space;
4. The option to borrow or lend through the use of credit and debt to shift economic decisions in time (i.e. buy now and pay later) and also to leverage the funds available for consumption, savings and investment. This introduces the concept of interest that governs all our inter-temporal decision-making;
5. The crucial role of capital and labor as factors of production;
6. Most important is the contextual variable of uncertainty surrounding all our decisions. This governs our perceptions of expected risk vs. return, i.e., what are the anticipated risks and payoffs for all possible decision options? The flip side of uncertainty is not certainty, but confidence.
1.1 Let's Eat! Now or
Later?
All economics really flows from one key concept: the simple decision of whether to consume today or tomorrow (whereby tomorrow indicates some indefinite point in the future). When you think about it, economics is founded on biology and human psychological behavior. Life is generated by the act of consuming, as all organisms go through the lifecycle of feeding, growing, reproducing, and dying. So, the desire, or imperative, to consume is fundamental to all economic analysis. We can observe our acquisitive nature very early in child development with some of the first words of a two-year-old: “mine,” “I want,” “give me,” and “more.” This is basic biology. It's no wonder we humans are such good consumers—it's in our DNA.
You might ask: Don’t we have to produce something before we can consume it? But this just recalls the chicken or the egg paradox of which comes first.[6] Our ancestors on this planet were consumers long before they were producers. Hunter and gatherer societies lived from hand to mouth until they learned how to preserve meat and cultivate grains. Such “technologies” allowed these societies to overproduce relative to immediate consumption needs and to save the surplus for the proverbial "rainy day." You may also have the perception that you produce primarily to provide for your family and leave a legacy for your progeny, but this just means that at some point in the future somebody else will be consuming what you produce today. The purpose of all production is eventual consumption (because, really, you can’t take it with you and there’s no reason to produce unless the product is eventually going to be consumed).[7]
What we don’t consume now is saved, but it can also be “invested” in production, thus increasing our stock of goods for later consumption. This simple decision problem of what to consume now, and what to save and invest in order to consume later, is where human psychology enters the economic equation.
Let us consider the simple decisions facing a farmer at harvest time: how much corn to consume and how much seed corn to put aside (save) for next season, to eat then or plant (invest) for another harvest. If the farmer’s family consumes all the corn during the first winter, they will grow fat and happy but could face starvation when the grain runs out. If they save all the corn for next year’s planting, they will surely starve before they can even get it in the ground. This process implies a kind of balance of flows across time: this year’s harvest flows into next year’s, which flows into the following year, and so on. Like the farmer, we too seek to find an equilibrium level that allocates our resources between present consumption and saving to yield the ‘crop’ we need to harvest next year, all the while making sure we have a comfortable cushion of ‘stored corn’ to consume through the winter. The more we save and invest ‘seed corn,’ the larger our total harvest grows (to a point). Anything that upsets this delicate balance will threaten our long-term survival and that of our families and communities.[8] This logic applies equally to the entire world economy. Today's consumption demands support today's production levels (i.e., the people who eat corn keep the farmer in production); today's savings supports today's investment in future production (the farmer’s seed corn is saved and reinvested in next year’s crop); and that future production provides for an increased level of future consumption (another bountiful crop feeds more people next season). This is how market societies grow their economies. It can be a virtuous cycle, or a vicious one when reversed. Think of how growing inequality and rising unemployment can reverse this cycle by undermining present consumption, making new investment in production superfluous.
1.2 I Like What You Have - Let's Trade
Our proverbial farmer does not need to survive on corn alone if he is a member of a wider community. He can take some of his corn and trade it for wheat, vegetables, honey, or whatever else other farmers or tradesmen produce. This establishes the concept of an exchange rate, or price, for corn relative to other goods and services. Trade is an important concept in economics. It allows us to specialize in what we do best and then offer the goods or services we produce in return for ones that others specialize in producing. This process of specialization increases our productive efficiency and makes everybody better off. This is true for farmers within a community, or for nations in the world market.[9] The desire to trade led to the development of markets. These markets introduced us to the economic concepts of supply and demand, where supply represents what we produce and sell, while demand represents what we buy and consume. The quantities supplied and demanded will balance at the correct market price of the good, often called the equilibrium price.
We will discuss in greater depth how markets work, but the general idea should be fairly obvious to anyone who shops in a supermarket. No longer do we have to grow our own produce or raise and slaughter our own livestock in order to put food on the table. And somehow, after buying all the food we can eat, we still have money left over to go to the movies, perhaps in a new car.
1.3 I Need Some $Money$
The development of trade led to the evolution of money. It is difficult to barter in cows, chickens, and bushels of wheat, so early trading civilizations developed substitute goods that could represent comparable values. Some were as simple as shells or cigarettes, but soon evolved into precious coins and letters of credit. Money as we know it, whether coins, bills, or checks drawn on banks, has becomes the universal measure of relative value. We price things in money and exchange money for goods and services.
The functional definition of money has three components: it is a medium of exchange, a unit of account, and a store of value. First, coins and bills are easier to take to market for exchange than the physical goods we want to trade. Second, we price things in a single unit of account—in the U.S. it is dollars and cents—and use this to compare values. And, third, our money (when deposited in a cookie jar, a bank, or invested) becomes a way to preserve purchasing power for the future.
We will discuss money in great depth throughout this guide, but the most important question concerns how we determine the currency’s value. For instance, what determines the value of a U.S. dollar bill? The answer may seem obvious, but it isn’t.[10] Our natural fascination with money sometimes obscures the fact that government-issued currency (called fiat currency) is only worth what it will buy. It was different when we used goats, cows, camels, or gold as currency because these other currencies (called commodity money or specie) also had utilitarian value. You can always milk or eat a cow or wear gold jewelry. A dollar, however, is only as valuable as whatever else it can be exchanged for. This is a bit more complex than it sounds, and is very easy to misunderstand. Consider the fact that we can’t really buy anything in France with a US$, except euros. We have to exchange dollars for euros before we can buy any croissants, cheese, or wine. Similarly, we cannot buy Italian wine with dollars, only with euros. If you buy an Italian wine in a U.S. shop, the importer, or exporter, has already exchanged dollars for euros. Another way of putting this is that as wine flows from Tuscany to New York, dollars are sold and euros bought. Same thing with Mercedes cars and French cheeses. A dollar can only be directly exchanged for goods denominated in dollars, i.e., U.S. assets or goods made in the good ole U.S.A. The value of a dollar is thus determined by all the goods and services available to buy with dollars, divided by the total stock of dollars.[11]
Supposedly, the supply of a currency is controlled by a country’s central bank. In the U.S., it’s called the Federal Reserve.[12] Because a country’s money consists of far more than bills in circulation, the actual supply and who controls it is a matter of serious debate. In the next chapter, in the section titled, The Mystique of Money, we will discover that whoever controls the supply of money holds the ultimate power to determine its value. You may be surprised at what we find.
1.4 Debt and Credit
The utility of money introduces the instruments of debt and credit and the concepts of borrowing and lending into our model. First, let us not get confused by the terms debt and credit, as they both refer to the same thing from opposing perspectives. Cred
it originates, or is issued, by a lender or a bond buyer; debt is incurred by the borrower or bond issuer. For example, when a business extends you credit, you assume it as debt.
Borrowing and lending are most often conducted through financial intermediaries (i.e., banks) and help redistribute consumption across space and time. For instance, I can borrow on credit to increase my present consumption, but the debt incurred also requires less consumption in the future in order to pay back the loan. I can also borrow on credit to invest in production that will increase my income in the future so that I can pay back the loan without shrinking future consumption. The key is whether the investment in the present increases income in the future. If it does and we can pay back the debt with interest, then we are richer for the debt assumed. But if our product and our incomes do not increase, the credit has only enabled us to borrow consumption and savings from the future, which will be bleaker for it. For example, if instead of getting more education, I borrow to buy a fancy sports car that doesn’t help me increase my income, then I will be poorer for it in the future because I will have to pay back the loan (with interest). Most people understand this intuitively and as it relates to them personally, but it also applies on the national scale, though there are crucial differences between individuals and governments.[13]
On the opposite side of borrowers are savers and lenders. Savers and lenders defer present consumption in order to receive returns on their loans to borrowers, which will increase the savers’ and lenders’ incomes in the future. This borrowing and lending relationship applies not only to bank loans but also to the issuance of bonds or mortgages. Bonds and mortgages are nothing more than debt instruments that specify an agreement to borrow a certain amount of money to be paid back over a certain time period with interest. Borrowing and lending, and saving and investing represent an exchange of 'goods' just like any other market transaction. The price of this 'good' is established by the various rates of interest specified in the terms. The bank, or financial intermediary, is nothing more than the middleman between buyer and seller. The balance, or equilibrium, between the supply and demand for funds is maintained over time by the interest rate.[14]
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