The most obvious illustration of the equivalence of RARs is a roulette table, where all the odds of different gambling strategies are virtually equivalent. If they were not, smart gamblers would only play the best odds ratios. Imagine if black paid off at 3 to 1 and red paid off at 2 to 1, yet there are equal numbers of red and black outcomes on the roulette wheel, so your chance of red vs. black is 50-50, but the payoff for black is 50% higher. Who, except the most mathematically challenged and blind, would play red until the RAR was adjusted so the payoffs were the same? Understanding risk and return can help explain many economic phenomena.
I stated above that uncertainty is the natural state of an unpredictable universe, but there is a variability of uncertainty in our lives. An approaching storm greatly increases the level of uncertainty governing our sense of well-being compared to a clear blue sky. The uncertainty of war is another example of uncontrolled uncertainty and risk. A commonplace economic uncertainty arises from price inflation and currency depreciation. Long term investment is greatly complicated if one does not have confidence in the value of the currency in the future. This is reflected in the nervous trading in gold over the past few years. Another case of uncertainty gathers around politics. What kind of impact will different political outcomes have on our economic well-being? Uncertainties associated with specific policy platforms will affect our longer-term economic decisions.
The flipside of uncertainty is confidence. When uncertainty over the future decreases, the level of confidence increases for successfully managing risks and profiting from change. The perception of these two subjective variables of uncertainty and confidence has a profound affect on the material value of capital. The more confident we are in the future, the greater we value capital; the more uncertain or fearful we are, the less we value capital. This is why, in the midst of a crisis, political leaders are wont to assure us that "the only thing we have to fear is fear itself." In capital markets, we’ll see that fear can be self-fulfilling.
By introducing some basic concepts, we have developed a simple model of the political economy that we can apply to various political and economic questions. As we will be using these concepts extensively, let us summarize:
All economic decisions are rooted in the decision of whether to consume now or later. Present consumption deferred is essentially saving, and our savings become a store of future value against risk (i.e. saving for a rainy day) or can be made available for investment. The decisions to consume or save, to invest or produce, are influenced by many factors, but primarily by the interest rate. A high interest rate discourages consumption, promotes saving, and indicates a strong demand for investment funds. A low interest rate encourages consumption, discourages saving, and indicates a weak demand for investment. Varying levels of investment and production reflect the possibilities of earning a return higher than the cost of borrowing. An expected positive return will increase investment and production. An expected negative return will have the opposite effect.
Individual economic decisions about consuming are linked together by opportunities to trade goods and services. This trade is facilitated by money in the form of a common currency that is easily exchanged for goods and services and convertible into other currencies.
Credit and debt, utilizing financial intermediaries like banks and securities exchanges, allow us to distribute our economic decisions across time and space. When presented with a promising investment opportunity, we don't need to wait until we save enough capital. Rather we can borrow it from other savers through the capital markets and pay it back in the future.
Capital and labor are the two primary factors of production that, when productively employed allow us to increase our levels of consumption and wealth over time. The cost of capital and the price of labor also determine how the product of wealth creation is shared across society. If the price of labor is high and the cost of capital is low, labor will receive a greater share of production and vice-versa.
Another important factor in the production process is the return to risk (or RAR), usually reflected in the cost of capital. Risk also determines how product is distributed between factors of production as higher risk-taking commands higher expected returns if successful.
All economic and financial decisions are heavily influenced by the subjective nature of uncertainty over the future and our confidence in predicting that future.
Naturally, there are many additional factors that influence our basic economic decisions and shape our society. The more we introduce, the more complex our analytical challenge becomes. The few offered here, however, are sufficient for analyzing and understanding many of the economic issues salient to our lives. I have included a more technical, but succinct, summary of this consumption model in Appendix A.
Chapter Two
The Macroeconomy
Most non-economists would probably be alarmed to learn that there is so much disagreement among economists with regard to macroeconomic theory and practice. This state of affairs contrasts sharply with that of microeconomic theory, which is concerned with how firms maximize profits and consumers maximize utility. Business owners are fairly clear on how to best increase their revenues, reduce costs, minimize the cost of capital, and manage risks in order to maximize their profits. Average consumers are also aware of how to manage their personal budgets, shop for the best prices, and allocate spending and saving behavior so they do not end up destitute (well, maybe not all consumers). In extrapolating microeconomic analysis to the macroeconomy, it is far less apparent that economic experts know what is happening until after the fact, or even if they comprehend it correctly at all. The recent financial and economic crisis, with its resultant policy controversies, only reinforces such doubts.
Assumptions about how rational individuals behave when faced with the straightforward task of increasing their incomes do not always lend themselves so easily to understanding how populations of millions of people attempt to navigate an unpredictable world. Businesspeople can confidently anticipate their local markets, products, and customers, yet fumble in the dark when it comes to anticipating where the entire economy is headed, especially when the macroeconomy is influenced by so many factors outside their control. Wars break out, natural disasters occur, public policies change on a political whim. All these factors have profound effects on the aggregate economic decisions of the entire population. Macroeconomic uncertainty and risk play a significant role in the decision-making of all market participants.
In order to have a basic understanding how the economy works, it may be helpful to think of the macroeconomy as a living organism made up of billions of individual cells. Through each of its billions of cells, this organism consumes, saves, invests, and produces. What it produces today is what it will consume, save, and invest tomorrow and so on into the future. So the economy must constantly recycle its product in order to grow. It (all of us together) recycles its product by constantly consuming, saving, investing, and producing in balanced proportions in order to sustain itself over time. If it fails, it will become unstable and be forced to correct itself or be corrected.[20]
People seem to grasp this concept most easily when it is applied to environmental concerns. If we deplete (i.e. consume) the planet’s natural resources and create nothing more, our civilization will soon perish. Let's see how sustainability applies to our simple economic exchange model. The watchwords for a sustainable market exchange economy are 1) balance, 2) coordination, and 3) pace. Perhaps the best analogy is to a marathon runner. Both legs must operate in tandem and coordinate in time in order to run the fastest while still staying upright. Then the runner must set a pace that is sustainable for twenty-six miles. If one leg gets too far out in front of the other, both get out of sync and the result is a face plant. If the pace is too fast, the runner will collapse exhausted. The two legs of the economy are supply and demand. It’s heart and lungs are the financial industry. The financial crisis of 2008 was our collapse and face plant.
; Remember the case of the farmer. If he consumes too much now without saving enough to replant next year, his current harvest will be his last and his family will be driven off the farm, perhaps eventually to starve. In the same way, if everyone consumes too much now, there will be insufficient saving and investment for tomorrow's consumption needs. Excess production to meet today's consumer demand will in time decline for lack of reinvestment, and the economy will slow. On the other hand, if we defer consumption too much in order to save, there will be excess funds available for investment, but insufficient demand today to justify putting those investment funds into new production. Investment returns will plunge, asset prices will rise as they are bid up by the excess investment funds, and the economy will shrink. As the economy shrinks, so will future demand, causing those asset prices that rose to fall again reflecting the economy’s losses and devaluation of capital.
We need just the right flows of consumption, savings, and productive investment over time in order to keep the economic system on a steady, sustainable path. But how can we determine the proper proportions for consuming now and later? This seems an impossible task to get right. It is possible, however, as sure as the world turns, if all economic decisions are guided by a functioning price system, with the most important price being the interest rate.
Economists have come to recognize that one of the most important functions of markets is the information value of their price signals that give feedback to producers, consumers, savers, and investors about what choices to make and which actions to take. The centralized command economies of the 20th century—those of the USSR or China, for instance—had no chance to perform this function, as their bureaucrats gave input and output directives to producers. One popular anecdote concerns the Soviet central planner who issued a directive for a ton of nails that would be needed for building. Naturally, the size of a nail matters for construction, but the factory fulfilled the order with twenty one hundred pound nails! What does one do with a hundred pound nail? That was not the central planner’s problem. The market feedback from those companies that needed the nails for construction were not taken into account.
Another amusing anecdote describes a Western economist’s experience surveying the construction of a large dam in China. He was surprised to see thousands of workers using shovels. Suggesting that the work would progress much faster with tractors and large earth movers, he was told that doing the work with shovels helped to increase employment. "I see," said the economist, "I thought you were trying to build a dam. If you want to maximize employment, you should use teaspoons!"
Open and competitive markets provide the most accurate price signals to market participants to insure that they make the right decisions. This fact is fairly uncontroversial and is widely accepted by all economists. The tougher question is: Why do markets fail?
2.1 Market Failures
There is a wealth of sophisticated economics studies into market failures, but we might better understand the basic issues with recourse to some simple logic and intuition. How does a functioning and self-correcting market work? The market feedback process follows the famous law of supply and demand, where supply and demand are brought into balance at what is called the equilibrium price. If the price deviates from this equilibrium, actions by buyers and sellers work to bring it back to the correct price to clear the market where supply equals demand. We experience this market rationalization every day. As consumers, we desire a particular good and are willing and able to pay a certain price for it. Producers are guided by the cost of manufacturing the good, their risks, and expected profits. If the price consumers are willing to pay is sufficient to cover the cost plus deliver a return on the risk-taking investment, producers can be assured a profit. Given an anticipated price, the producer offers a certain supply for sale. If the product inventory sells out, he can raise his price on the next batch or just increase production, whichever maximizes his total profits.
On the other hand, if buyers decide that the price the producer sets is too high, the producer will have left-over inventory. This negative feedback tells him he must lower his price and/or reduce production. As buyers and sellers meet in the marketplace and make trades everyday, their preferences are soon reflected in the prices and the quantities of goods exchanged. Market equilibrium is insured by a negative feedback process, whereby market participants respond to price deviations with actions that bring the price back to equilibrium. Anybody who shops for “sales” is enacting this negative feedback process. We know how well these market processes work when we walk into the supermarket and decide what to buy from its incredible array of choices. If you ever meet someone who has grown up in an un-free or non-market society, you will find that the first thing they marvel over is a modern supermarket stocked with foods from all over the world. They have never experienced anything like this because a society without market feedback has stores with empty shelves, long lines, and ration cards for the scant goods that do become available.
We should note here that labor also operates as a feedback exchange market with the wage being the equilibrium price that balances the supply and demand for labor at different skill levels.
Normally, goods and services markets rarely fail. Sometimes there are supply shocks, such as the 1970s oil embargo, during which the supply of oil was cut off and its price skyrocketed. Similarly, severe weather or droughts that affect the grain harvest will lead to spikes in the price of food. But these are not market failures, they are market shocks. Markets respond with negative feedback and the market soon returns to equilibrium.
One example of a true market failure is a natural monopoly, which results from efficiencies gained through large-scale production. The larger a company gets, the easier to beat the competition, leading to monopolistic pricing power.[21] Think of an electric power company or the original Bell telephone company.
Another important market failure is when costs are not included in the price of the good. Consider the pollution produced as a by-product of industrial manufacturing. The cost of the pollution is not paid by the producer or consumer but is borne by those who suffer from the pollution and its secondary effects. For example, increased lung disease by coal miners may be the cost they pay for cheaper energy prices for consumers and higher profits for coal mining companies. We call these types of failures externalities.
A third market failure concerns public goods, such as the military. In economics, public goods have very specific conditions that differentiate them from private goods. It is important to understand this distinction. Private and public goods are not defined as goods provided either by private companies or by the government. Public goods, in fact, are defined as non-rival in consumption and non-excludable. Non-rival means that my consumption of the good does not affect yours, and yours does not affect mine. Non-excludable means that I cannot exclude you from consuming the good, thus I have no power to actually make you pay for it. A good example of a public good is clean air, the more I breath does not reduce the amount you can breath and I cannot exclude you from breathing the same air. On the other hand, a juicy steak is not a public good. If I eat it, you cannot. If I produce the beef, I can exclude you from partaking in its consumption. Private goods can be produced, priced and paid for; public goods cannot. The private market will not provide public goods because they cannot price such goods, receive payment, or prevent people from free-riding. The private market fails because the desired good is not produced and consumed.
We can easily see how this applies to national defense. If someone else pays for the U.S. Navy to protect the nation (through taxes?), as a U.S. resident I still get the same protection, even if I don’t pay taxes. So, the federal government provides for our mutual protection as a public good paid for out of general tax revenues they do collect. A private navy could not provide this good unless they had the power to tax. (Unfortunately, we have convinced ourselves that old-age pensions and healthcare are public goods, even though they have been provided for by priv
ate markets for centuries.)
In general, most market failures can be traced to some form of information failure whereby faulty price signals do not bring the market into equilibrium through the feedback process. A good example is the used car market, where the seller knows the true value of the automobile and the buyer does not. If the car is a lemon, the seller has an incentive to hide this fact and pass the car off to an unsuspecting borrower at a high price. Buyers are aware of this possibility and offer a lower price. If the car is truly a good value, the seller refuses to lower the price. Only if it is a lemon does he lower it in order to make a fair sale. So people keep good cars, refusing to sell them cheaply, and lemons tend to dominate sales in the used car market, which is why so many people are willing to pay more for dealer guarantees.
By and large, goods markets that are open to competition will adjust quickly to changing conditions and maintain equilibrium between supply and demand. The consumer goods we buy every day rarely fluctuate wildly in price day to day or disappear permanently from the store shelves. In the capitalist macroeconomy the most crucial markets are those for labor and capital, both of which are vulnerable to frequent market failures. But before we tackle capital and labor markets, we must address the mysteries of money.
2.2 The Mystique of Money
In the previous chapter we briefly introduced the concept of money as one of the essential building blocks of our simple model. We also stated that the most important but confusing question about money concerns its value. Unfortunately, the mystique of money is perpetuated by a monetary system that is shrouded in secrecy and obscured by complexity.
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