by Judy Jones
Known in financial circles as the Fed (and not to be confused with the feds), this government body, our central bank, wields enormous control over the nation’s purse strings. In fact, it’s said that the Fed’s chairman is the second most powerful man in Washington. He and his six colleagues, or governors of the Federal Reserve Board, direct the country’s monetary policy. Simply put, they can alter the amount of money (see “Money Supply”) and the cost of money (see “Interest Rates”), and thereby make or break the economy. When the Fed tightens, interest rates rise and the economy slows down. When the Fed eases, interest rates fall and the economy picks up. Or so it used to be. The balancing act is so difficult, and the Fed so mistrusted, that its actions often have a perverse effect. So much for simplicity.
Many swear that the Fed is the root of all economic evil. In his landmark work, A Monetary History of the United States, 1867–1960 (coauthored by Anna J. Schwartz), Milton Friedman placed blame for the Great Depression squarely on the Fed (for tightening too much). He hasn’t stopped berating it since, and he has plenty of company. Beating up on the Fed is a popular sport—unfair, perhaps, but understandable. A little history: The Fed, created in 1913 by an act of Congress, grew steadily in strength during the Depression years. By the 1950s, it had evolved into an independent force, free of the pressures of Congress and the president. Checks and balances for the economy, you might say.
This explains why many presidents have had a love-hate relationship with the Fed, praising it when interest rates are falling, then cursing it when they climb. Members of Congress, similarly, are often frustrated by the Fed’s independence, and periodically threaten to limit its autonomy.
But the Fed tends to be blissfully immune to criticism. Board members pursue their own lofty economic objectives and routinely cast blame on Congress and the president for mismanaging the economy. MONEY SUPPLY
This is what the Fed is supposed to control but has a hard time doing. For decades, the Fed, and the people who make a living analyzing what money is doing, monitored the money supply because of the effect it was believed to have on the national economy. The Fed measures the money supply in three ways, reflecting three different levels of liquidity—or spendability— different types of money have. By the Fed’s definition, the narrowest measure, M1, is restricted to the most liquid kind of money—the money you’ve actually got in your wallet (including traveler’s checks) and your checking account. M2 includes M1 plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds. M3 includes M2 plus large-denomination ($100,000 or more) time deposits, balances in institutional money funds, repurchase liabilities, and Eurodollars held by U.S. residents at foreign branches of U.S. banks, plus all banks in the United Kingdom and Canada. Last time we looked, the M1 was around $1.2 trillion; the M2, $6 trillion; and the M3, $8.8 trillion. The Fed, by daily manipulation, can alter these numbers. If the Fed releases less money into the economy, interest rates rise, corporate America borrows and produces less, workers are laid off, and everyone’s spending is cut back. When the Fed pumps more money into the economy, the reverse happens. And if it moves too far in one direction or another, the Fed can create a depression (the result of too much tightening) or hyperinflation (the result of too much easing).
In theory. The problem is that in practice, the Fed is far less able to control the economy than it was twenty years ago. There are billions of dollars sloshing around outside the banking system (some of which have even found their way to places like Russia and Argentina). What’s more, today a lot of people are holding money that used to be counted as checking or savings deposits in mutual funds. Oh yes, and let’s not forget booming credit, which in effect creates a money supply of its own. INTEREST RATES
Money, like everything else in the economy, has a price. Beginning in the late 1970s and lasting right through the 1980s, that price was high. Home mortgages carried double-digit rates, and borrowing on a credit card routinely cost about 19 percent. The Vietnam War, wage and price controls in the early 1970s, the quadrupling of oil prices, a flabby Fed, and a ballooning budget deficit had all done their part to push prices up—including the price of money.
Eventually, though, a tougher Fed and a sluggish economy brought down inflation, which allowed interest rates to fall. By 1993, some rates were at their lowest levels in thirty years. And to everyone’s surprise, they were even lower ten years later. This is at least partly because of the huge U.S. trade deficit. Foreign central banks and investors now hold much of the United States’ debt. Because their interest rates tend to be even lower than ours, they take the dollars we send them in exchange for record amounts of imported goods and send the dollars back to the United States, in effect recycling them, in order to take advantage of our interest rates.
DISINFLATION
It’s an awkward word, for sure. Simply put, disinflation occurs when prices rise, but at a slower rate than they did before. So what was so significant about it? First off, it was a big and welcome change from the 1970s and early 1980s, when rising prices (and wages that didn’t keep pace) eroded incomes, and consumers faced sticker shock every time they went shopping. Disinflation, and continuous low rates of inflation—say 2 percent to 3 percent a year—provide greater certainty and stability and allow economic activity to proceed at a steadier pace. (Though folks who expect to earn 10 percent on their certificates of deposit aren’t necessarily happier.)
In the 1970s, galloping inflation was our biggest problem. In the 1980s, we were obsessed with the budget and trade deficits. The 1990s shaped up as the decade of disinflation and price increases have been very moderate ever since. First, both the Fed and the financial markets will work hard to push interest rates higher if prices start rising. That, in turn, will immediately dampen animal spirits and lower the inflation threat. Second, the U.S. recession of 2001 made it harder for manufacturers to raise prices, and the slow recovery has kept price increases tame. But the stiffest curb on inflation comes from the growth in world trade. Read on. GLOBAL COMPETITION
The bulk of economic theory, and our understanding of how economies actually work, is based on the assumption that most nations are largely closed—that is, self-sufficient in the production of most goods and services, open to trade only at the margin. In the real world, however, trade across borders has been going on for centuries. And in recent decades, with the growing sophistication of technology, communications, and transport, it’s become easier and cheaper for more people in more places to make and ship goods and provide services. The value of world trade, in real or after-inflation terms, has grown 6.5 percent a year since 1950. For every $100 billion more in goods that are traded around the world, growth is pushed about $10–20 billion higher than it otherwise would be, economists say.
Free trade, or relatively free trade, unencumbered by stiff tariffs or quotas, is responsible for this heady growth. That sounds positive and, for the world as a whole, it is. New workers and consumers join the global community as trade increases—witness the way millions of Chinese have gotten rich, thanks to China’s adoption of decidedly uncommunist economic policies. Consumers in industrialized nations like the United States can obtain goods that are cheaper than those made at home, and that should improve living standards. But that benefit is not uppermost in the minds of workers in the United States, say, who lost their jobs because U.S. manufacturers decided to set up shop in Taiwan or Mexico and produce the same goods more cheaply there.
Today Americans are more and more aware of an alphabet soup of trade and economic relationships, from APEC and ASEAN to NAFTA and the WTO (see “Dead-Letter Department,” page 407). All these groups spin an elaborate web of relationships on which future growth will be based, often within loose confederations of nations. Are these relationships progrowth? Definitely But they also guarantee that economies are anything but closed. So long as trade continues to grow, wages and prices in relatively wealthy countries will be under downward pressure. And that mean
s that global competition keeps the inflation threat low. FLOATING CURRENCIES AND THE GOLD STANDARD
All that trade is being financed with U.S. dollars, Japanese yen, the E.U.’s euro, and a whole lot of other currencies. Every day the value of those currencies vis-à-vis each other shifts—or “floats”—according to supply and demand on foreign-exchange markets, and in recent years there’ve been some mighty big swings as economic policies change and speculators and investors make big bets.
Businessmen and tourists complain about the uncertainty that accompanies floating rates, but there’s little alternative. Once upon a time, back in the 1960s (and for almost a century before), foreign-exchange rates were rigidly fixed—and only occasionally repegged—and major currencies such as the dollar were valued in terms of gold. (By this standard, gold was worth $35 an ounce, and dollars could be turned in for gold.) This setup supposedly lent stability to the world trading system and ensured that currencies possessed real, not inflated, value. But currency and investment flows across borders became so enormous in the late 1960s and early 1970s that the system (known as Bretton Woods, after the New Hampshire town where it was devised following World War II) unraveled. In 1971, Nixon took the United States off the gold standard.
Today there are still people who hanker for a gold standard. Gold, the argument goes, has intrinsic value, while paper does not. But advocates of a return to the gold standard are like octogenarians who reminisce about the good old days, forgetting about gas lamps and outhouses. The mechanistic inflexibility of the gold standard is what forced us to go off it. Floating rates allow these corrections to occur continually and with relative calm. The system may not be perfect, or even comprehensible, but it looks as though it’s here to stay.
Adventure Economics
Because so many people share in the national pastime known as playing the market (which means, of course, the stock market, and used to refer specifically to the granddaddy of them all, the New York Stock Exchange, but now includes nine markets that are linked electronically), it’s worth your while to know the rudiments. The way to do that is to follow the stock tables and read the daily market summaries. And if you’re really ambitious, you can learn about a few other types of markets— like the bond and futures markets—and think of yourself as a financial polyglot. THE STOCK MARKET
A stock represents a share, or fractional ownership, in a company, and a very fractional one indeed. Large companies have tens of millions of shares outstanding. Companies sell stocks (the first time they do it’s called going public) because they need other people’s money. With a strong base of stockholders’ equity, as the pool of ownership is known, a company can buy machinery, fill orders, pay its executives handsomely (and its workers not so handsomely), and even borrow money.
Stock comes in two forms—common and preferred. The difference lies chiefly in dividend policy (see below) but is also important when a company liquidates. Then the preferred shareholder is, as the designation implies, in a better position than the common shareholder.
A dividend is the reward, or payoff, a company gives the stockholder for investing in it. It’s actually a piece of the profits, but don’t imagine for a minute that all the profits are distributed proportionally. No way: Profits must be plowed back into the company’s operations (and, some might say, into executives’ pockets). But something has to be given to the investor who helped make things happen, so dividends of anywhere from a few cents to a few dollars per share are handed over quarterly. The company sets the dividend rate, and every so often may decide to toss a few more coins the shareholders’ way. But a company, if it is in poor financial shape, may also suspend paying dividends on common stock or cut a dividend. The company, however, must distribute dividends in full to preferred stockholders before it pays common stockholders, so it is the latter who gets their dividends axed first in a pinch.
A capital gain is the profit you make on the sale of your ownership in a company, provided the company has done well, its stock is in demand, and its stock price has risen: You hit big in the market.
A loss is a loss. Today—or the day you bought stock—was not your day.
The stock market is where winners and losers get together. Sometimes it seems like a party, other times like a wake. Big winners and losers determine the mood, because the real market makers are pension funds, banks, corporations, and other money managers, all known as institutional investors. The little guy is just that, and he tends to get swept up in or under the tidal waves institutional investors create. The cardinal rule of any market, the stock market included, is buy low, sell high, but if everyone did that successfully, there’d be no markets to speak of. For any person who buys low, there’s somebody selling low, and for anyone selling high, there’s someone willing to buy high. Why? Because of expectations and greed. A person selling low is trying to cut his losses and figures the worst is yet to come, so it’s time to bail out. And a buyer shelling out big bucks is convinced that stock prices will go still higher, and he wants to cash in, even if belatedly.
The herd instinct accounts for the tidal waves and derives from the fact that people are always looking over their shoulder to see what the next guy is doing. More often than not, for no good reason, they figure he must be right and they must be wrong. Institutional investors can suffer this market paranoia in the worst way, so you see how a herd can form and really trample the market. Since institutions invest in many names, stock prices across the board tend to move in line with each other during big market swings. All sorts of things can affect the herd, from a change in tax legislation to a political assassination. But the herd can also behave in ways that have no obvious explanation, as it did when the bull market began in August 1982. And it can turn tail and run in the other direction, as it did when the market crashed in October 1987. It can also be spot-on correct, as it was throughout the 1990s.
If you watch stocks on a daily or even weekly basis, the numbers will tell the story of how the market is behaving.
The Dow Jones Industrial Average (DJIA), or simply “the Dow,” the most widely used measure of market activity. It’s an index of the price of 30 stocks (but a huge amount of money) which trade on the New York Stock Exchange, or NYSE, where the largest companies are listed. Dow Jones publishes the Wall Street Journal and Barron’s and provides financial information.
NASDAQ stands for National Association of Securities Dealers’ Automated Quotations system. The NASDAQ_ stock market is now the fastest-growing, most technologically advanced market, listing everything from hot new issues to established companies such as Apple Computer. Trading volume is second to the NYSE’s.
AMEX stands for the American Stock Exchange, a distant third in trading volume.
Some other averages are far more comprehensive. Among those widely cited: the Standard & Poor’s 500, which tracks large stocks, and the Russell 2000, which tracks small ones.
Then, too, remember that the stock market isn’t the only market around. There’s the options market, where people buy and sell the rights to buy and sell stocks, believe it or not. This way, for less money than it would take to actually buy stocks outright, people can play the market. Without ever owning a stock, they can win big or lose big on its movement. Playing the options market can be (if that’s possible) even more of a crapshoot than playing the stock market.
Also dicey for some, though useful for others, is the futures market. This market was originally devised to help out farmers and manufacturers who used farm products. Contracts for future delivery (within a few months) of grains, pork bellies, and assorted other items could be bought and sold, providing a hedge against anticipated rising costs or falling revenues. But the market has burgeoned in recent years with the inclusion of a host of new contracts (from foreign exchange to stock indexes) and scores of new players. Today hardly anyone active in the futures market takes actual delivery on a contract. The fastest-growing component of the market is in financial futures—Treasury bills and the like— be
cause fluctuating interest rates are still another cost businessmen want to hedge against and speculators bet against.
Once the staidest of them all, the bond market is not the safe haven many conservative investors think it is. Used to be, a company that wanted to fix its borrowing costs for ten or twenty years would borrow money from investors by issuing bonds. The U.S. Treasury did the same, as did the individual states and thousands of municipalities. The investor would buy the bond, receive a fixed amount of interest each year from the issuer, and get back his principal when the bond matured. Bonds were boring because usually, nothing changed. Prices were steady because interest rates were generally steady. If interest rates moved slightly higher, the resale price of the bond, or its price on the secondary market, moved down a notch. No big deal.
That’s all changed. Low inflation has brought low interest rates and big profit-taking to the bond market since the early 1990s. But bond market investors, who only get paid the value of the dollars they lend, aren’t trusting, and that makes the bond market anything but staid. Who knows where interest rates will be ten or twenty years from now? A sharp upturn in rates would send prices plummeting—producing big losses for investors holding long-term (twenty- to thirty-year) bonds. So this nightmarish guessing game has buyers and sellers tripping over each other to secure mere fractions of a percentage point in interest.
So much for the markets. If you feel like dipping your big toe in, be forewarned: The old adage that you should never invest more than you can afford to lose still holds true. In fact, it’s truer than ever. Leave the fancy stuff and the big bets to the old hands. After all, they know more than you.
Or do they?
Economics Punch Lines
In the past, all the good jokes were about doctors, lawyers, and politicians, but now that economists control the politicians and make more money than the doctors and lawyers, it’s they who’ve become the butt. As it happens, the jokes themselves are far too long to recount here. Which means you’ll have to be content with the punch lines:
