Uncertainty
The lack of certainty. A state of having limited knowledge where it is impossible to exactly predict the probability of a future outcome.
Yield
In general, yield is the rate of return on an asset. Often used to compare debt securities like savings accounts and bonds. Because financial instruments fluctuate in value, yield is often different than the interest rate.
Yield Curve
The yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower. The time frame of the yield curve extends from overnight rates to 30 year bonds. The normal yield curve relates to the time value of money, where liquidity on a one-year loan differs significantly from a 30-year loan. The shape of the yield curve is a function of this liquidity preference, the supply and demand for credit, and the level of uncertainty in the economy.
Notes
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[1] It took almost 200 years to accumulate the first $trillion of Federal government debt. Since 2007 we have added to it at over a $trillion per year. As of July 2011, it stands at $14.5 trillion. This is not as frightening as it sounds because, unlike you or me, governments never have to pay back debt and they can effectively create money to pay the interest (this is explained in the sections on money in Chapter Two). But the overall level and trend of national debt does have long-term consequences for our standard of living.
[2] This credit-debt cycle is illustrated by a flow-chart graphic in Appendix C.
[3] Daily foreign exchange (Forex) trading volume is now estimated at over $4 trillion each day.
[4] See any articles by Daniel Kahneman and Amos Tversky. The development of their experimental findings is known as Prospect Theory.
[5] The concept of time is fundamental to these five elements of our model. Time differentiates static (one-period) models from dynamic (two or more period) economic models. One should consider that the notion of time is what distinguishes humans from most other species. Time gives us a sense of our mortality and promotes the search for the meaning in our existence. Time also introduces change. Thus, time has a profound effect on our behavior. Static economic models are rather unrealistic in this light.
[6] The chicken or the egg paradox results from a circular feedback process: you can’t have eggs without a chicken and you can’t get chickens without eggs. We’ll find that the economy follows the same circular logic and economically we don’t create “something from nothing.”
[7] Adam Smith identified the preeminence of consumption first in The Wealth of Nations: “Consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to only so far as it may be necessary for promoting that of the consumer.”
[8]Volatility in the agricultural sector—caused by droughts, floods and pestilence—goes with the uncertainty of weather. History is marked by such monumental events as the 19th century Irish potato famine and the 1930s dust bowl in the U.S. Midwest.
[9] David Ricardo is famous for illustrating comparative advantage and the gains from trade, a concept that is fundamental part of every economics student's education. His simple examples can be referenced here: Comparative Advantage.
[10] During a Senate hearing in March 2011, Federal Reserve Chairman Ben Bernanke was asked for his definition of the dollar. He replied, “Whatever it will buy.” Technically, his answer was wrong. Instead of defining the role of the dollar as a medium of exchange, a unit of account, and a store of value, Mr. Bernanke actually referred to what determined the ‘value’ of a dollar. The question was meant to focus on how the value of the dollar is affected by Federal Reserve monetary policy that helps determine the supply of dollars. The true value of the dollar is “whatever it will buy” divided by the supply of dollars in circulation.
[11] This relationship is represented by the famous Quantity Theory of Money that states as PQ = MV, where P = prices of goods, Q = quantity of goods, M = the money stock and V = the velocity, or turnover, of the money stock. So, P x Q equals the total value of goods and services and M x V equals the money supply. A stable currency value would imply that a constant ratio be maintained by PQ/MV. The quantity theory gets a bit too esoteric for our discussion of money, but the problem largely preoccupies our Federal Reserve. They have to anticipate how many new dollars (M) are needed based on the growth of PQ (another way of stating GDP) to keep the price level (dollar value) stable. Most economist liken this to trying to drive by looking in the rearview mirror.
[12] The Federal Reserve System was created in 1913 by Congress “…to provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.” It should be noted that the Federal Reserve is not a Federal government agency, but a quasi-public/private institution. It is owned by its private member banks, but its policymaking committee, called the Federal Open Market Committee, is made up of twelve members, seven of which are appointed by the U.S. president and confirmed by the Senate.
[13] One important difference is that unlike we mortals, governments never die, so the government can carry a debt on its books in perpetuity as long as it can pay the interest on the debt. On the other hand, when we die our estates must settle our affairs. Another critical difference is that the government may control the supply of currency, meaning that it can pay back its debts by running the printing presses. Germany did this during the Weimar Republic, leading to the hyperinflation of the 1920s and the collapse of German society. Today, many countries are constrained because their governments must borrow in foreign currencies, which is why countries like Thailand, Argentina, and Iceland were forced into a debt crisis—they had to pay back in dollars or euros. So, printing money to pay debts is not as simple or painless as it sounds because governments eventually pay a high price for financial mismanagement. The U.S. remains a special case because of the dollar's status as a world reserve currency. More on this later.
[14] There are numerous interest rates in the financial system that apply to a wide range of borrowing needs. The interest rate that is controlled by the Fed is the most important one in policy terms. This is called the Fed Funds rate and it is the interbank rate that banks charge each other to borrow and lend banking reserves. All other interest rates in the financial system key off the Fed Funds rate.
[15] Increases in the price level (inflation) erode the real value of money (the functional currency) and other items with an underlying monetary nature (e.g. loans and bonds). Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The real interest on a loan is the nominal rate minus the inflation rate. For example, if you take a loan where the stated interest rate is 6% and the inflation rate is at 3%, the real interest rate that you are paying for the loan is 3%. It would also hold true that if you had a loan at a fixed interest rate of 6% and the inflation rate jumped to 20% you would have a real interest rate of -14%. Banks and other lenders adjust for this inflation risk either by including an inflation premium in the costs of lending the money by creating a higher initial stated interest rate or by setting the interest at a variable rate. As the rate of inflation decreases, this has the opposite (negative) effect on borrowers.
[16] China attempted the reverse logic—that a shrinking population could enhance economic growth—by enforcing its one child family policy. But a declining birth rate and shrinking population is a warning sign of future economic consequences. Most economic prognosticators now foresee a China that will grow old before it grows rich.
[17] This should grab your attention because economic theory assumes we are indifferent between gains and losses and always seek to maximize our gains. But this does not seem to be true. Think about your decisions and how the risk of loss affects them. Likewise, finance theory assumes people are risk a
verse, but this also is not always true. When faced with a likely loss, people are willing to take a risky gamble to avoid it. Also, in many situations people take on unnecessary risks in hopes of securing a large gain. These people are often found vacationing in Las Vegas or buying lottery tickets.
[18] See various articles by Daniel Kahneman and Amos Tversky.
[19] This price action is insured by arbitrage trading, which is just a fancy word for the decision to sell a high priced asset and buy a low priced asset with the expectation that the prices will converge. When we buy lower-priced, seasonal fruit we are conducting a form of arbitrage.
[20] The notion of the self-correcting economy has been at the heart of economic policy debates of the past century. Market fundamentalists believe the economy is largely self-correcting, provided there is no political interference in the process. Interventionists believe government policy management is required to stabilize the economy. The problem is that politics will always intervene in the private economy, so the question becomes how, when, and how much. This conflict remains, and will remain, unresolved, at least for the foreseeable future.
[21] This is why we have anti-trust laws and public utilities. The reasons for these are not germane to our discussion but can easily be explained by the nature of certain industries.
[22] Despite being the named the Federal Reserve and the .gov web address, the system is not a part of, nor controlled by, the Federal government. Many claim this was a ploy to make the public think it was a Federal government agency. If so, it seems to have worked.
[23] While the Fed can force banks to redeem the credits it lent them (contract money), it cannot force them to make new loans by forcing them to borrow (create money). Thus, the process of Fed control over the money supply is often loosely described as pulling or pushing on a string. Pulling on a string works, but pushing on it doesn’t work nearly as well. The Fed’s ability to expand the money supply depends on the voluntary cooperation of the banks.
[24] It’s important to remember that the US government is not bound by debt obligations the same way we mortals are. A government that issues it’s own currency carries its liabilities forever, in other words, it never has to settle up, it can always issue more currency to pay debts. The danger then is not insolvency or bankruptcy, which is what you or I would face, but the gradual depreciation of the real assets and productive capacity of the dollar economy. A holder of US Treasury bonds (or for that matter, a Social Security claimant), will always be paid off, the question is whether that payment will be worth anything in real value terms.
[25] I say “can” because credit creation requires the cooperation of the banks to issue new loans and borrowers to borrow, neither of which is happening now with the de-leveraging response to the 2008 financial crisis.
[26] Goods prices were also held down by cheap foreign imports.
[27] Roger Farmer, How The Economy Works.
[28] Economists have often noted this, but in retrospect. Too little, too late. In the midst of the housing bubble, Federal Reserve Chairman Alan Greenspan said that asset bubbles were difficult to perceive until after they popped. The most notable analysis of financial crises is attributed to economist Hyman Minsky. An asset bubble driven by new credit is often referred to as a Ponzi scheme. A Minsky moment is that moment when the Ponzi scheme collapses, kind of like popping a balloon. In the words of one past Fed chairman, it is the Fed’s job to take away the punch bowl just as the party begins to take off.
[29] Statistically, uncertainty can be defined as the spread of the distribution of possibilities. This is called the variance of the distribution.
[30] This means we don’t let the market process alone determine the price, but assign this task to our so-called monetary experts who run the central bank. It is only pure faith that allows us to hope these experts are no less fallible than the pope!
[31] A detailed discussion of these statistics is beyond the scope of this brief guide but can be referenced here: http://www.shadowstats.com/.
[32] Over history international currency regimes have varied between fixed rates that do not change, pegged rates that are relatively fixed until the government unilaterally changes the rate (an example is when a nation fixes its currency to the value of the US$), and floating rates that vary day-today depending on currency trading. A discussion of these various regimes is unnecessary here except to note that the major trading states have been operating under a floating rate regime since 1971, when the U.S abrogated the Bretton Woods agreements.
[33] The economist Frank Knight in his now famous book, Risk, Uncertainty and Profit, first formalized the difference between risk and uncertainty. Knight defined risk as a measurable quantity that depended either on a mathematical law of probability or an observed frequency distribution. Uncertainty is an immeasurable quantity because we lack data on which to base probability estimates. So taking a risk is like gambling in a casino, while uncertainty is like a meteor hitting New York City, getting eaten by a timber wolf in Central Park, or a nuclear terrorist attack. In Donald Rumsfeld’s parlance risks would be “known unknowns,” while uncertainties would be “unknown unknowns.” Nature doesn’t make a clear distinction—a threat is a threat—but our theories of economics and finance do, and often erroneously.
[34] New financial instruments, such as derivatives, can be very efficient tools to diversify or hedge risk, provided they are transparent and regulated to prevent fraud.
[35] This relationship between risk, return and price can be confusing. If the return of an investment stays the same, but the purchase price goes up, then the risk goes up (with higher price paid, there is more to lose) and the expected risk-adjusted rate of return falls. Remember the RAR is a ratio that will change as either risk or return changes.
[36] To explore the fallacies of ‘democratic’ voting it is instructive to investigate Arrow’s impossibility theorem.
[37] Economist Robert Frank first examined the winner-take-all phenomenon in his 1995 book, The Winner-Take-All Society.
[38] As a professional policy analyst and non-celebrity I must admit I find this a bit disconcerting.
[39] Two political scientists have also examined the political policies behind winner-take-all in their 2010 book, Winner-Take-All Politics.
[40] This follows the standard economic law of supply and demand: when supply increases and demand stays the same, the equilibrium price must fall in order to get supply and demand back into balance.
[41] We should not confuse the exchange value of the dollar to its real value. Exchange value refers to the dollar’s value relative to other currencies, such as the euro or yen. Real value refers to whatever the dollar can buy in terms of U.S. goods and services.
[42] Inflation is different than relative price changes between different goods. For example, oil and gasoline prices can rise and other prices fall as we shift consumption patterns. Inflation is a rise in the general price level and must be accommodated by an increase in the supply of money. If the money supply does not increase, price pressures will lead to relative price changes. Heating oil and food prices may rise, while prices of discretionary goods like clothing or durable goods may fall.
[43] A nominal interest rate of 10% with an inflation rate of 12% yields a negative real rate of interest of -2%. Under these conditions a rational strategy is to borrow as much money as possible and buy hard assets that will hold their real value. This can go on only as long as lenders will lend at a negative return. In other words, not that long.
[44] For a good demonstration of rapid growth off a low base, we can take the experience of China and India over the past two decades. If one wants to have 10%+ growth rates all one has to do is to follow a generation or two of zero growth rates – there's no place to go but up.
[45] Fannie Mae = Federal National Mortgage Association (FNMA); Freddie Mac = Federal Home Loan Mortgage Corporation (FHLMC).
[46] Recapitalization of the real estate market means house prices
rise as interest rates decline. For example, if you have an income of $50,000, you can afford a $150,000 home at 6.5% mortgage rates, but a $250,000 home at 4.5% rates. Lowering interest rates merely ‘recapitalized’ existing houses at a higher value – same house, higher value. It’s illusory alchemy, though, because interest rates will go up again, forcing a recapitalization of the housing stock at lower price levels.
[47] Direct taxes are those you pay through federal, state and local levies. Indirect taxes occur with the depreciation of real assets through inflation and/or depreciation of the currency. These are often called “hidden” or “stealth” taxes. These are far more politically palatable because we don’t “see” them.
[48] Some will argue here that there are three possible outcomes: hyper-inflation, deflation, or persistent stagflation, and that monetary policy can forestall both inflation and deflation. (See MMT) The rejoinder is that the price of forestalling inflation and deflation is endless stagflation, as experienced for the past two decades in Japan. The resolution of this argument is realizing that monetary phenomena cannot substitute for real economic phenomena in the long term. Either we have productive policies that promote real wealth creation or we have a dangerous shell game of money illusion.
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