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Free PDF Book: The little book of economics – how the economy works in the real world

Revised and Updated

The little book of economics - how the economy works in the real world

Introduction to Economics

FOR MOST AMERICANS, THE economy is like the plumbing: something to ignore as long as it’s working. In the past five years, it feels like every pipe in the house has burst. Americans have endured a financial crisis, the worst recession and weakest recovery in memory, exploding government debt, and the threatened breakup of Europe’s single currency.

In the presidential elections of both 2008 and 2012, the economy trumped all other issues by a gaping mar- gin. Economists have been repeatedly surprised by events, and often can’t agree on what to do about them. Yet people are hungrier than ever for their insight, devouring economics-themed blogs and hundreds of new books about the economy. “Like being an undertaker during a plague, business is good for the economics profession,” Greg Mankiw, an economics professor at Harvard University, wrote on his blog.

I have been following the economy since—well, childhood. My mother was an economist (long since retired) who delighted in applying the dismal science to raising her four children. I’m sure we were the only kids in town whose weekly allowance was indexed to inflation.

I took economics in college, though not intending to write about it; I just wanted a fallback in case journalism didn’t work out. Right out of college, I joined a metropolitan daily newspaper that put me on the night shift covering local politics, crime, and the like, a lot of which never made it into the paper. The business section, however, had lots of space in it and regular hours, so I got a transfer. Soon, I was writing about the economy and the markets, and loving it.

After years of interviewing policy makers, investors, and business leaders, I have found that the economy in the real world often differs from the economy in text- books. Simple concepts like growth, unemployment, and government debt can be measured in multiple ways. Central banks don’t think about inflation the way text- books do. And the subject is often cloaked in dry numbers and mystifying language.

I wrote The Little Book of Economics to provide non-economists with a practical, plain-language guide to the concepts they encounter in their daily lives, whether as students, business managers, or concerned citizens, from growth, unemployment, and inflation to deficits, globalization, and the Federal Reserve. But the world keeps changing and in the past two years, new forces and insights have emerged. Let me note three in particular.

First, I’ve discovered my economics textbooks still have plenty to offer. Take interest rates. You can think of them as a price that must rise or fall so that the sup- ply and demand for saving are in balance. For most of my career, policy makers tended to worry about too much borrowing and rising inflation and investors fret- ted about interest rates heading up.

The past few years are a reminder that the opposite can also happen. If everyone wants to save and no one wants (or is able) to borrow, interest rates can fall to zero and remain there, and spending will remain mori- bund. Government deficits may be essential—because if no one else is borrowing, someone has to. The eco- nomic concepts behind these phenomena were first developed in the 1930s, and as Paul Krugman, a Nobel Prize–winning economist, notes, many economists have since forgotten them. That included me. I have since rediscovered them in my old textbooks.

Second, seemingly sensible economic solutions often fail the test of political acceptability. Recovering from a financial crisis can be hastened if the government buys up private borrowers’ bad debts and makes them less onerous. But voters don’t want their taxes subsidizing bankers or spendthrifts. Deep divisions among American politicians on how to solve its fiscal problems have made it difficult to put forward solutions that even economists agree would be helpful, such as a higher gasoline tax or a later retirement age.

Third, the rest of the world’s influence on the economic lives of Americans has grown dramatically. Global markets determine the price of oil, gold, and increasingly interest rates, and even wages. Under- standing where the American economy is going depends increasingly on decisions in Frankfurt and Beijing, not just New York and Washington.

This edition of The Little Book of Economics has been extensively revised and updated to reflect all these things, and more. A new chapter on currencies explains the euro crisis. As in the original, I’ve used simple language, examples, analogies, and minimal numbers, with- out sacrificing the underlying theory. While I’ve avoided jargon, the rest of the world isn’t so considerate, and so each chapter has a section called “Into the Weeds,” which explains the essential data, people, and lingo of each subject.

They’re perfect primers for anyone who wants to follow the markets and the economy in detail. I’ve boiled down everything in each chapter to “The Bottom Line.” If you read nothing else in the chapter, read this: It will tell you the essentials in a few short sentences. Finally, those who want to dive deeper can visit my website, www.gregip.com, where I have a section suggesting books, articles, and resources on the topics covered here along with my latest articles.

We’ve been through a lot of trauma in the past few years, but economics still provides essential tools for understanding what is going on. This book puts those tools in your hands.

 

Chapter One: The Secrets of Success

How People, Capital, and Ideas Make Countries Rich

 

POP QUIZ: THE YEAR is 1990. Which of the following countries has the brighter future?

The first country leads all major economies in growth. Its companies have taken commanding market shares in electronics, cars, and steel, and are set to dominate banking. Its government and business leaders are paragons of long-term strategic thinking. Budget and trade surpluses have left the country rich with cash.

The second country is on the brink of recession; its companies are deeply in debt or being acquired. Its managers are obsessed with short-term profits while its politicians seem incapable of mustering a coherent industrial strategy.

You’ve probably figured out that the first country is Japan and the second is the United States. And if the evidence persuaded you to put your money on Japan, you would have been in great company. “Japan has created a kind of automatic wealth machine, perhaps the first since King Midas,” Clyde Prestowitz, a prominent pundit, wrote in 1989, while the United States was a “colony-in-the-making.” Kenneth Courtis, one of the foremost experts on Japan’s economy, predicted that in a decade’s time it would approach the U.S. economy’s size in dollar terms. Investors were just as bullish; at the start of the decade Japan’s stock market was worth 50 percent more than that of the United States.

Persuasive though it was, the bullish case for Japan turned out completely wrong. The next decade turned expectations upside down. Japan’s economic growth screeched to a halt, averaging just 1 percent from 1991 to 2000. Meanwhile, the United States shook off its early 1990s lethargy and its economy was booming by the decade’s end. In 2000, Japan’s economy was only half as big as the U.S. economy. The Nikkei finished down 50 percent, while U.S. stocks rose more than 300 percent. Far from catching up to the United States, Japan’s economy in 2010 fell to third largest in the world, behind China’s.

What explains Japan’s reversal of fortune? Simply put, an economy needs both healthy demand and supply. As is well known, Japan’s demand for goods and services suffered when overinflated stocks and real estate col- lapsed, saddling companies and banks with bad debts that they had to work off. At the same time, though less well known, deep-seated forces chipped away at Japan’s ability to supply goods and services.

The supply problem is critical because in the long run economic growth hinges on a country’s productive potential, which in turn rests on three things:

  1. Population
  2. Capital (i.e., investment)
  3. Ideas

Population is the source of future workers. Because of a low birth rate, an aging population and virtually nonexistent immigration, Japan’s working-age population began shrinking in the 1990s. A smaller workforce limits how much an economy can produce.

Capital and ideas are essential for making those workers productive. In the decades after World War II, Japan invested heavily in its human and economic capital. It educated its people and equipped them with cut- ting-edge technology adapted from the most advanced Western economies in an effort to catch up. By the 1990s, though, it had largely caught up.

Once it had reached the frontier of technology, pushing that frontier outward would mean letting old industries die so that capital and workers could move to new ones. Japan’s leaders resisted the bankruptcies and layoffs necessary for that to happen. As a result, the next wave of techno- logical progress, based on the Internet, took root in the United States, whose economic lead over Japan grew sharply over the course of the 1990s.

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