Chapter 4

How a Perfect World Would Work

This is no longer your parents or grandparents economy. As we saw, knowing that “it's the economy, stupid” and understanding how the economy actually operates, are two different things. Worse, the economy is a living, and therefore, changing thing.

Our standard of living, the types of jobs we have, our employment opportunities, what we can afford to buy with the money we make and even the full range of goods that we can purchase are all wrapped up in the way we organize and operate our economic activity not just now but also in the future. So, yes, it is the economy! But the key is not to be stupid about it and the way you do that is by understanding how all the players in the economy operate.

How We Got Here

The economic structure we currently operate in the United States is the result of centuries of trial and error. It is not something that came from the Founding Fathers, though there are many who think that is the case. Yes, the Constitution set out the basic principles for the nation, but it did not tell us how to run the economy. Indeed, there are economic positions in it that have been abandoned. So we cannot look to the eighteenth century for what we have today or what will emerge as we go through the twenty-first century.

The economy also didn't come from following the directions in an economic textbook or a self-help manual entitled “How to Form an Economy.” Yes, economists like to take credit for just about anything that good that has happened in or to the economy and disavow anything bad, but economic theory has evolved to account for the many changes in businesses and household activities that are the result of progress. And, of course, economists rarely agree on just about anything. There is an old saying that if you laid every economist end to end, you still wouldn't reach a conclusion.

What we are saying is that there is no one single economic concept that has or will drive the economy. Instead, it is a collection of ideas that have been fitted together in a patchwork of ways to create our current system. We have part free-market economics, part government controlled. And some markets have government run elements existing side by side with private-sector companies. Simply put, you cannot describe the form of this economy in simplistic terms. It is much more complicated.

As for Wall Street, it is doubtful that anyone there would or could claim credit for the structure. They would argue that Wall Street principles are critical to the success of the economy and maybe they should be used more generally throughout business, but the markets constitute only one element of this complex system.

While many current and past politicians, political analysts, and pundits like to say they helped create the intellectual foundations of the current system, few have actually had any real impact on the current structure of the system. Undoubtedly, politicians have helped push the economy in different directions, created short-term changes in the structure of business relationships and even affected the way we look at the economy. But politics played only one role in the evolution.

A lot of different forces, individuals, circumstances, and actions have come together to create the economic system we now live under. Thus, understanding how it evolved from a simple structure to the current complex world economy we now have is critical in comprehending how it actually works. And as conditions change, the perception of what is right or wrong may change, but the ability to evaluate the new ideas will still be founded in the understanding of where we came from and where we are going.

If you know why something came about, you have a basis for suggesting ways to change it to make it better. When politicians tell you their program is best for the economy while their opponent's will hurt it, you can make your own judgment. Knowing how the economy works will allow you to better critique those who claim they have the answers to all of our economic ills. Economics touches every aspect of our lives, and we shouldn't leave it up to others to tell us what to think.

Building the U.S. Economy: A Journey through Time

The transition from the early days of the country, when both the population and the number of businesses were fairly modest to the mind-boggling international colossus we currently have was quite slow. But is it necessary to describe that process in detail? Yes, at times this discussion about the historical evolution of our economy might seem tedious, proceed slowly, and often explain obvious facts and relationships. But when we get to the destination, it should be clear that the time was well spent.

The goal of this one geeky chapter is to give you the foundations to understand not only why we currently have the economic conditions we are dealing with, but also the means to evaluate where we might be going. And maybe most important, you will be able to participate in the discussion of the solutions.

The Very Beginning: Hunting, Fishing, and Doing Your Own Thing

Once upon a time, in a land of small populations but great abundance of natural resources, there lived a people. Actually, this is not a fairy tale. These were the original inhabitants of the country, and geography determined where they lived and how they survived. We are not talking about one group in one place, as this is a vast nation. Instead, even 400 years ago, there were a variety of economies that existed. Those primitive but successful organizations laid the foundation for the future, and how they evolved is the story of this section.

Since water was the most critical aspect of life, close proximity to oceans, lakes, and streams were where you had to be if you were going to survive and prosper. The people back then probably weren't told by their doctors that they should drink eight glasses of water a day, yet they still knew what they had to do. Clean, drinkable water was and still is the basic building block of any location.

That, of course, brings us to one of the foundations of economics: If there is a need for something, what economists call demand, it will be supplied in one form or another. The essential nature of water created the drive to find critical supplies of water, and that formed the basis for household locations. If the sources of water happened to change, people had to follow the water. That may have led to annual migrations or even periodic mass movements and complete changes in long-term living situations when water sources dried up.

Of course, what people did to survive, wherever their choice of location, was also determined by what Mother Nature managed to provide in addition to water. Since they lived close to the water, the inhabitants got a significant portion of their food from the seas or lakes or streams. The variety may not have been great, but as long as it was abundant, people could live and stay in one place.

At the same time, the food sources were not limited to what was swimming around. Water is needed for physical survival, but that didn't mean the source of food had to be from the bounty of the seas or streams. The land itself was fertile, and the growth of crops for food was extensive. Forests covered much of the land, and they were filled with a wide variety of food sources. Those were not limited to animals but plants as well. To secure the food supply, people became farmers, hunters, or gatherers, not just fishermen. These were means to an end that small families could pursue and survive at.

Wow. Think of it. All you need to survive is a place where there is water. You could hunt or fish or farm for part of the day and party the rest of the time. The streams overflowed with fish, the oceans were full of seafood, and the forests contained herds of animals and flocks of birds. You didn't have to worry about rent or mortgage payments, taxes, or even global warming. All you had to do was go out of your shelter, whatever that might look like, and find your living.

All that seems to be great, and for many it was. But it also had huge challenges. To survive, people were required to provide all their needs by themselves. There was only so much time to find the food, maintain the shelter, and enjoy life. Even then, context mattered. Food supplies were based on availability, which was frequently determined by seasons and weather. Shelter and clothing needs varied by climate and seasons, and so did production. But they did it all, and they prospered.

Evolution Phase 1: Specialization

The more things remained the same, the more they had to eventually change. The first critical part and maybe most meaningful development that moved the economy from the simple hunter/gatherer/fisherman system to what we have now was specialization.

Remember your first economics course? I know, most of us have done our best to forget that course, as it was one of the dullest, most boring classes you ever had. But if you search your memory hard, you may remember you learned about specialization when the idea of the division of labor in producing goods in an industrial society was introduced in that freshman economics course.

The discussion of how labor can be best used to produce the most, or what economists call productivity, tended to be centered on the lessons of the industrial revolution. The factory collected people who had a variety of skills, threw them together, and gave them one specific job to do. Workers became adept at whatever it was, and the production-line method led to vast increases in output.

But what is missed in those discussions is the simple fact that the division of labor was introduced and in many ways perfected well before the sweatshops came into vogue. It actually started when a tribal leader said to one of the clan members, “Hey, dude, you are one a heck of a hunter. Why don't you go into the forest and get the family some deer for dinner.”

The reality that chief recognized was that as extended families grew, the different skills needed to provide all that the group required were not evenly distributed. Not surprisingly, some people could hunt or fish better than others. The ability to build a shelter, no matter how rudimentary it may have been, was hardly universal, especially when there was only a small group to choose from. Making clothes, organizing activities, and creating safe keeping for extra goods were not capabilities that everyone possessed equally.

Thus, as time went on and the size of the society expanded and the needs increased even more, it became clear that it would be a lot more efficient (though I doubt that was the word used) if only a few of the most skilled secured the food, while those who knew what to do with the bounty prepared it, those that were good at construction created the shelter, and the rest did whatever it was that they were best at doing. That is, even in the small family setting of early America, some form of specialization made economic sense, as the standard of living, if not the simple survival, of everyone depended on all doing the best they could by producing as much as possible.

That restructuring from a strict self-sustaining activity to dependence on others for survival was the true beginning of the modern economy. The transition from individualistic economic activity to group production allowed for—indeed, even facilitated—the creation of the large tribes, clans, extended families, troops, religious orders, or whatever that came to populate the landscape. The advantage was that each person's skills would be used to support the general good. Interdependence, not independence, was what would guide all future forms of economic activity.

The evolution of the economy from one that produces all to all who produced for all was inevitable because it just made economic sense. With more skilled people producing the different types of goods and services, the quantity of goods produced expanded, the availability of food became greater or more varied, and the quality of everything tended to improve. As a consequence, everyone's standard of living increased. Not surprisingly, the radical change where individual efforts were now turned into coordinated economic activities didn't come easily. Some of the most basic issues of any society had to be resolved. The biggest and most important one was, “Who gets to do what?” While it might sound nice that those that could did, while those that couldn't did something else, it was a lot tougher in the real world to make those decisions. Not everyone was going to agree with the determination of expertise.

Once the distribution of jobs was determined and the many varied responsibilities were divvied up, the next major concern had to be addressed: “How were the goods going to be distributed?” More may be the result of specialization but who gets the more was always going to be an issue of discontent. The distribution of income was a problem then as it is now.

Government: Benevolent Dictators and Other Fun Ways to Distribute Goods

In this early economy, you had people producing goods and people consuming goods, just like we do today, but not everyone made everything they needed. Critically, the means to transact the business relationship didn't exist. That is, it took something or someone to decide who did what and who got what.

Conflicts were naturally arising as to the fairness of any distribution. To resolve those disagreements, a “governing entity” of some form or manner had to be created. That could be an individual or a group, but it was entrusted with the process of structuring behavior to conform to the general good.

Someone had to do that, and the simplest way was to have a benevolent dictator make those choices. That is, the head honcho had to decide. Subsequently, a council may have been added to express their views and spread the blame. These were the people who told others what to do and what they were getting or at least oversaw the process so it didn't get out of hand and evolve into conflict, destroying the tribe.

Not everyone could be made happy. And you didn't have a choice once the decisions were made. There were no labor markets or alternative job opportunities. That is important to remember when issues of income distribution are considered.

Since authority was required in this new economy, the idea of “government” became a necessity. In essence, the “polity” was the inevitable consequence of going from an individualistic to group economy. As such, it meant that government was supposed to do the bidding of all the people to create the most good and, in doing so, unify the group. Good luck with that. But it did work for those societies that accepted the leadership in a fairly unquestioned manner. When authority was questioned, battles broke out and the nations broke apart.

For a very long time in this country, tribes of different economic orders ruled the land, and those economies provided all the essentials: food, clothing, shelter, and defense. But the greatest challenge and change came when the types of goods and services that could be created began to take on even more specialized qualities as the nations came in contact with each other. That is where the next stage of development comes into play: trade.

We Are Not Alone!

While tribes may be able to create a number of different goods and services that people want, there are limitations to what can be produced. Variety is indeed the spice of life, especially when it comes to possessions. We have always been awed and desirous of things new and different.

Ultimately, the somewhat isolated tribes had to start intermingling with each other. Many of those meetings were not particularly peaceful. Just as we like new things, we also distrust others we don't know. But there were also opportunities to meet and greet different groups under controlled circumstances. Those connections formed the basis for the next great change in societies and economies: people saw that there were things in life other than what they were capable of creating.

Without any alternatives, groups had to be satisfied with what they made themselves. The options were limited to the way those particular clans did things. Variety may or may not have been highly valued. But once there was contact, people saw there were options that frequently they never had seen before. The reality of what they were missing became a factor in their lives.

The interaction of different nations producing different types of goods led to the first complex aspect of economies: trade. Seeing that others have products that appear to be great ideas, or at least something worth having, fostered needs that ultimately had to be satisfied. People wanted those products, and if they couldn't make them themselves, then they had to find means to secure them. Again, where there is demand, there is likely to be a way to create a supply.

Barter Can Only Get You So Far

In the beginning, trade occurred through the simple concept of barter. I have something you want and you have something I want, and we arrange to swap goods or services. Bartering was relatively easy because that is what had already been happening within the tribes. Those who provided the food swapped with those who provided the clothing, who swapped with those who provided the shelter, and so on. That is the case even if all the goods were put in one big pile and everyone chose.

However, when the swap meets were between nations rather than within tribes, there was a fundamental issue that created conflict: You have to agree on what constitutes a fair trade. Haggling and the ability to make the best deal became an essential skill. But it was also true that not all deals could be consummated.

Making a deal can become difficult since not all products have the same value to each person. You may like something but do you really need it? If you don't, that makes you less willing to part with the product that you have so painstakingly crafted. The differences in how a good is valued can be extreme, and it depends on the perceptions of the individuals doing the trading.

Indeed, when you start talking about individual desires, you finally get to the fact that we are simply a bunch of consumers. We want lots of things, and we want even more of the things we don't have. Trade accentuates that state of mind. It creates demand for goods and services that people might never have even thought about (which is also the foundation of advertising, but that is a different story).

But what is desirable and can be traded is a personal thing that is very dependent on where you live and what time of year it may be. That is, context matters. It is easy to sell wool blankets to people who live in the Snow Belt but not to those who live in the desert. If your air conditioner is working fine, you really don't have any need to trade for one, especially if it is winter—which reminds us of that old saying that you can sell ice in the summer but it's an awful lot tougher to do so in the winter.

Bartering thus has its limitations and frequently can fail to create an agreement between two willing bargainers. Even if there is a large number of certain goods, that doesn't mean the goods wind up being exchanged for something else.

The inability to complete the trade may have little to do with the desire to have the deal succeed. The issue that causes the deal to collapse usually comes down to price. The price of a good is simply the value that someone else places on it, not just the value the seller places on it. Essentially, it is how much you are willing to exchange one good for another, and each seller has his or her own opinion of value.

While a barter system can work under certain sets of circumstances, as it still does in many ways, no barter system could handle the growing number of specialized products that were being offered once populations expanded and came into contact with each other. It can be very hard to exchange a skateboard for an oil change. Worse, the way a price was determined often depended on goodwill and trust. When you didn't know someone well, you were usually quite leery of any exchange.

To have a successful barter trade, you had to have a good that someone wanted, and the other trader had to have a product you needed. But that was only the first step in the process. Each side had to be able to determine how much their good was worth in terms of the amount of the other good they were trading for. That becomes quite difficult when the goods are not divisible. It is unclear if someone would trade half an arrow for a smaller-than-needed length of rope. And nothing happened unless there was a need for the items being offered. If you weren't in the market for an axe, so be it.

Something had to be done about the problems inherent in a barter economy. The ever-expanding sizes of tribes made it possible to create a whole variety of products, but getting something in return for those goods was becoming more difficult. Out of that necessity developed the concept of money. Instead of trading goods, a generally accepted alternative item was used, and that is what opened up the world to full-scale economic development.

Money Makes the World Go 'Round

The conflicts created by the barter system were holding back economic activity. If only something could be found that would be accepted and used to make a deal, then people would not have to simply trade one product or service for another. That alternative had to be created and since need is the mother of invention, ultimately it was. Money, whatever it was called, looked like, or was made of, was the critical breakthrough that made it possible to move beyond the limitations imposed by the barter trade system.

What is money? No, it's not something we can never have enough of. Okay, we can never have enough of it, but that is not the point. Money, as any good first-year economics student will tell you, is a medium of exchange. It is something that can be used to secure a good. But the rub in all this is one simple problem: money has to be generally accepted. That is, people and businesses have to believe that if they hold the money, they can get something for it.

There is a great burden placed on money by the need that it be generally accepted: it must hold its value. If you are to hold money, you have to believe that it can be used not just immediately but, much more importantly, in the future. If it can't, then there is no reason to keep it in your wallet, put it in the bank, or stash it under your mattress, and you are back to a barter system. Therefore, anything that harms the value of money will limit its usage. And the last thing an economic system can afford is the loss of the usage of its money.

The concept that money is in effect a storehouse of value has clear implications for the economy of today. It means government must back it unconditionally. Public policy has to be managed in a way to lessen any potentially negative impacts on the currency.

One of the worst things that can happen to money is that it loses its purchasing power. Why hold something that gets you less in the future, especially if it has no intrinsic value? Ugly green pieces of paper that are full of germs are hardly something that you want any part of unless there is a really worthwhile reason to hold it.

Rising prices, which we call inflation, is unquestionably the worst thing for money. It means that the longer I keep some cash in my pocket, the less I can buy. The higher inflation, the more our savings are destroyed. As a result, I do whatever is possible to rid myself of this evil thing, and that means I buy everything as soon as possible.

No economy can persist if we don't look to the future but simply live in the present. If no one wants to hold money because of the fear that it will lose value, then we wind up with the equivalent of a barter economy. Money that has stopped being held and used as a vehicle to exchange for other goods is no longer money. It is just another filthy piece of ugly paper.

Thus, we fight inflation, which reduces purchasing power. That is the economic foundation for the Federal Reserve System. Someone or some group or government entity must be out there to provide some confidence that our money has value. The Fed was created largely to make sure that everyone is willing to hold money by insuring that it's not just in God that we trust but also the government itself.

Money Is Not Enough (Don't We Know That!)

Once we have money, the possibilities of the economy become unlimited. Thus, the creation of a monetary system is just the beginning of the modern economic story. We know the actors; they are businesses, households, and the government. We just don't know how they work together. We don't know what they do or why they do it, and that has to be explained.

Consider the most basic of economies where we have only those who make the goods and those who buy their products. That is, we have an economy that has only businesses and consumers. Let's focus on the corporate world for a while. In our simple world, one person made the goods. But it's time to get real, and since we have moved way past that point, we have to consider the workings of companies that make complex products.

In order to produce in today's world, a boatload of workers need to be hired. So the ad goes on the web site and the resumes are e-mailed, and the human resources group sorts through it all. Candidates are chosen, interviewed, offered a salary, and the person goes to work. Sounds great and it is. But there are still some issues to be resolved.

First and foremost, how does a company make money after all those workers show up? That may sound like a crazy question to ask since all you have to do is sell a product at a profit and, bingo, you're on easy street. But in the simple economy, not everything works in a simple manner.

First, after you have hired your employees, you have a small thing called payroll. If a firm is to pay its workers, it has to have the funds to do it. The only way it can get money is by selling its products. Who can the firm sell its products to? Either its workers or someone else's employees. So if a firm pays people wages to work for them, it is hoped and expected that they will buy lots of goods in return. That works out fine as long as everyone, no matter where they work, spends all their income.

So, if we all take our fantastic salaries that have made us all so fabulously wealthy (just kidding) and go out and spend them, then all the money given to workers winds up back in the hands of firms in the form of purchases of goods. That way, a company can get back what it gives up in payments for workers and for the other inputs to production.

But I smell a rat here. First of all, where are the profits? Well, they come from paying the business owner, and that is all. There's nothing left over. Okay, I can live with that for now. But I am still worried about the idea that to make that minimum profit everybody has to spend all their money. Okay, maybe that is not totally dumb as lots of people live from paycheck to paycheck and we do like to hit the malls really hard. But not everyone shops till they drop.

While lots of us do manage to spend everything we earn, some of us are a little more cautious. We manage to take a little off the top of our paychecks and hide it away for a rainy day. That's a strange thing called savings. When that happens, not all the payments to workers wind up being spent on goods. Some firms find they paid more to produce the goods than they earned. That's called losses, and it's hard to make up losses through volume.

If households need to spend all they earn but don't, Houston, we have a problem. How can firms survive if people decide to stop spending a little? Not easily. Could it be that this wonderful economy that has evolved over the decades has to collapse? Well, not really.

We have to find a way to get the money not spent back into the economy. How that happens is simple: get someone to collect all those savings and have them find a way to convince others to spend it. When there is a challenge, there always seems to be a solution that will ultimately be found, and this one is no different.

The way we get the money back into the economy is to create a company that buys and sells savings! What is that business called? Well, how about a bank! We need banks, or more generally, the financial system, to make sure what is taken out of the economy in the form of savings is put back into the economy. Essentially, a bank is nothing more than a way to collect and distribute all the funds that businesses and individuals don't want to spend right away.

The Banking System Made Simple

The economy we are following has really started to evolve. It began with self-sufficiency, moved to interdependence of production, then the need for money, and now we have the complexity of putting the money to work.

One of Ben Franklin's famous sayings is “a penny saved is a penny earned.” Indeed, for a long time, saving money was considered a key to the economy's success. But there are two sides to every coin, and that is true when people don't spend all they earn.

As we have shown, if you set aside some of your hard-earned income, that is potential demand for goods that doesn't go to businesses who are trying desperately to sell their wares. You can buy things or save, but you cannot do both with the same money. So you have to look at savings as a loss of spending.

If savings means businesses get less money, is that bad? The answer is absolutely not! But it is a problem. Money coming out of the economy in the form of savings—with businesses, it is retained earnings—and not going into demand for all those wonderful things that businesses want to sell you has to find its way back into the economy. Maybe you don't really need all that stuff, but that is not the point. If you don't buy it, it cannot be made.

The savior of the economy put at risk by all those selfish savers is the financial system. It is the mechanism by which savings are recycled so what leaves the economy gets put back into the system. It is the original “green” industry. Okay, bad pun.

The recycling responsibility of the financial system is simple. Think of a bank as a very large piggy bank. Instead of people stashing their cash in their mattresses, strongboxes, or their backyards, they give it to a business to hold on to. That company has to convince everyone that it is safer to leave their money with them than if they kept it at home. They have nice big safes with huge steel doors that not even Jessie James can break into. Okay, that may not be totally true, but you get the picture.

So all those people who have been hoarding their money at home take it to the local building and loan association, thinking it's now a wonderful life. They have savings, it is in a safe place, and they are even getting a little payment for keeping their money with those nice people. Maybe the return savers get, which is called interest, is not a whole lot, but it is more than if they kept it in cash. And you don't need a security firm to protect it either!

Of course, that is only the first step in the process. The financial institution has lots of money that they have collected, but they are also paying interest on that cash. There is also the cost of the safe, the branch employees, loan officers, accountants, and, of course, lots of money for the bank executives. So something has to be done with the savings. That is where lending comes in.

In the real world, while some people don't spend all they earn, others need extra money to buy things they cannot pay for out of savings or income. Some of us do both. We save but want to buy a new SUV that costs a lot more than we have in the bank. Companies need cash to buy new machinery, equipment, and software or to build new plants. And, of course, governments tend to need money from time to time, and they go looking for someone to fill their coffers.

Into that gap between those who have money and those who need cash rides the banks. They make their money by making loans. The borrowers then run out to the dealer to buy the shiny new vehicle and businesses invest, and it is indeed a wonderful world. In essence, banks are simply redistributors of savings. They take money from households, businesses, and even governments and give it back to households, businesses, and governments.

The implication of this recycling responsibility is that the financial sector is the linchpin of the economy. For the business world to operate smoothly, the funds that come out in the form of savings, which are leakages from the system, have to be returned in the form of loans, which are injections back into the economy. If the financial system stops working, households don't get the loans they need to buy vehicles, houses, or appliances, and businesses cannot invest in new machinery or build new plants. Everyone is left holding their savings or retained earnings, and that would mean the economy would grow an awful lot slower, if at all.

But while banks are the linchpin of the modern economy, that doesn't mean they always know what they are doing. Indeed, most of the recessions in the nineteenth century had their roots in bank runs and failures. When banks made mistakes, they were usually doozies. But people needed to trust that their money was safe from the Jessie Jameses who rode in on horses or who inhabited the back offices. Once they lost that trust and panicked, they pulled their money out, and guess what—there was no money to grease the wheels of economic activity!

Eventually, it dawned on those who ran the financial system and the government that maybe there should be some overseer of banking activity. In 1913, the Federal Reserve was created, largely to keep herd on the banking sector so that credit would flow and bank failures would be kept at a minimum. And it did that, until the Great Depression, though you can hardly blame the Fed for that.

The Fed has evolved greatly over the past century. It is the sheriff of bankland as the system's key regulator. It now plays the critical role of making sure that the currency doesn't lose value; that is, it is the major inflation fighter. Did you really think Congress was capable of doing that? You cannot have a complex economy if the currency is under attack and not accepted by households and the business community, so someone who was not running for office had to keep control of things, and it is the Fed.

The Federal Reserve has also been burdened with other responsibilities, in particular, helping to ensure full employment. After World War II, the Full Employment Act made full employment (what a surprise) one of the two mandates of the Fed. Now, the dual responsibility—full employment at low inflation—is what the Fed tries to balance.

That means the Fed has to lean against the wind. Its policy is wholly dependent on context. When things get going too boisterously, the Fed has to take the punch bowl away. You don't want things getting too out of hand and inflation rearing its ugly head. If the economy is weak or in recession, the Fed's job is not to worry about inflation but to put the pedal to the metal and get things going again. They might be concerned that inflation would come back eventually, but they will worry about that after the recession or Great Depression is gone.

Big Brother Is Watching Over Us

Okay, businesses are humming along, consumers are spending like crazy, and the financial system is greasing the wheels of industry with the guidance of the maestros at the Federal Reserve. Sounds great, right? Yes, but there is a missing link here. In the primitive world, a benevolent dictator or counsels made the decisions that ensured everyone followed the rules. In the modern world, that role is played by our favorite whipping boy, the government.

The role of government in society is wide ranging and depends on the wishes of the voters—or at least that is the theory. But there are a number of overarching aspects of government that directly impinge on the economy. Our fearless leaders like to spend money, and to pay for their insatiable appetite to give us all we want, they either tax us or borrow money.

As to how the economy is affected by government actions, let's limit the discussion right now to the concepts of spending, taxes, and borrowing. In a later chapter, the horrors and wonders of the spending and taxing decisions will be discussed, but right now it's all about the way the economy works in general.

So you run for office, get elected, and tell everyone that you will make the roads smooth, the schools great, and provide police and fire protection. At the national level, you are strong on defense and like to help those who are in need. There is something in those public services that just about everyone wants, and so we get them. That means the government is out there spending lots of money on things everyone or anyone wants.

How do our politicians pay for that largesse? They have really only two options: they can tax you or borrow money. What is a tax? As far as economists are concerned, it's just a transfer of income from the private sector, either households or businesses, to the public sector. Instead of you or me or the local business down the street having money to spend, our friends in Washington or state capitals or town halls have the money. That is a leakage out of private spending. We no longer have as much money to do with what we want, and the deeper government dips into our pockets, the less we have.

Thankfully, at least for economic activity, the tax money burns a hole in the pockets of the politicians even faster than it burns a hole in ours, and our friendly elected officials spend it on all those things that they think we want. What has happened is that private demand has been transferred into public demand.

The only thing missing in this discussion is a small thing called the budget. On one side of the ledger you have spending. It is a lot, and it is probably rising. On the other side are revenues. The basic source of that money is taxes. But sometimes—well, if you are the federal government, most of the time—the tax receipts fall short of the spending and you wind up with a budget deficit. To make that up, the government goes to the public and borrows money. That takes money that might have been lent to businesses or households and sends it to the public sector.

Basically, the government is also just a redistributor of income. It takes money out of the wallets of businesses and households, reducing their spending power, and spends it on things our elected officials think are needed. Taxes are leakages from private demand, while spending is an injection of money back into the economy. The larger the budget deficit, the more the government puts back into the system than it takes out.

Context should matter to politicians, even if their actions imply that they don't think it does. When the economy is booming, it would be really irresponsible to pour more fuel on the fire and possibly increase inflation by spending like crazy. It's tough enough for the Federal Reserve to deal with businesses and households without having to worry about what the big spenders in Washington are doing.

Alternatively, though, it was done as recently as December 2012, it really makes no sense to raise taxes when the economy is weak. Is it logical to take more money out of people's pockets or business coffers when there isn't enough demand to begin with? There is a time for every purpose, though we can never be sure who in Washington knows that. So the government must consider more than the next election when it makes policy. Did we really write that?

The World Is Our Oyster and We Are Its

The economy is almost complete. To this point, all we have done is look at the United States as if it exists by itself. To paraphrase John Donne, no country is an island, entire of itself; every country is a piece of the world. And that is just as true of the United States as it is of any other nation. Indeed, the remaining missing link in this narrative is the introduction of world trade.

We have seen how the interchange of goods between tribes changed the primitive economy. Trade among nations has done the same. It allows for the introduction of goods and services that might not be available without those relationships. It creates competition for products we produce and for our dollars.

While economists agree that trade can be good, there are some upsides and downsides that should be kept in mind. In a future chapter, a full discussion of the good, the bad, and the ugly aspects of trade will occur. Here, we are interested only in how trade affects the level of economic activity in the United States.

There are two parts of trade: we can sell goods to foreigners, or they can sell stuff to us. In the first case, when we ship products overseas, we are exporting the things we make. So ships leave our ports and wind up in Europe, Asia, South America, or wherever. What do we get in return? Money! We get cash that people in other countries could have used to buy their goods but instead they buy our products. That is great because we now have another source of demand. Instead of depending just on U.S. consumers, businesses can get sales and income from foreigners. The more the merrier, and the better off we are.

But the downside is that we love to buy everything foreign. When China ships products to the United States, those goods are called imports. They are frequently cheap, and we can buy lots of them. That's great because it always helps to have a supply of low-cost products available.

Unfortunately, there is no such thing as a free import. We have to pay for the products we lust after. We do that with our earnings. So we ship dollars out of the country to pay for the vehicles, clothes, appliances, and everything else that we purchase. However, that is the exact reverse of imports. We spend our hard-earned income that could have been used to buy goods made in America on goods made somewhere else. That means there is less demand for American companies.

Basically, an export of a good is actually an import of income or demand while an import of a good is actually a shipping out of our income or spending power. What that tells me is that you want to have as many exports as possible, for that increases sales for U.S. companies. However, you might want to limit imports since they reduce demand for American-produced goods.

The difference between exports and imports is the trade balance. When exports are greater than imports, it means more money is coming into the country, and that helps generate more demand. So a trade surplus, which is what this is called, is good for the economy.

When imports exceed exports, the economy suffers. More money is going out than coming in. This is called a trade deficit, and the larger it gets, the more money that leaks out of the U.S. economy and into the economies of our trading partners.

Keep in mind that imports by themselves are not bad. As I said, they allow for a wider selection of products, usually at lower prices. But there is a cost of trade, and that occurs when we run trade deficits, which reduce economic growth.

Now we have the basics of our economy. From a simple family that managed to survive on its own, a complex economic system has been created, with a variety of actors. We have people who produce things, and they are called businesses—at least the Supreme Court thinks they are people. We have individuals who purchase goods, and they are our consumers. We even have concept of world trade. Instead of neighboring tribes that are trading with each other, we have different countries. The government oversees all this securing the common good.

All that is great but what is left out is the concept of business cycles. People may want to buy, business may want to sell and governments may want to do whatever governments want to do at any given time. But the willingness and ability to do that is greatly affected by where you are or frequently where you think you are in a business cycle.

What are business cycles? Basically, the economy doesn't go straight ahead. You have to think of it as being a roller coaster, with long stretches of growth. Indeed, since World War II, the growth periods have averaged five years, though the expansions have varied greatly in length. The shortest period was just one year, from July 1980 to July 1981. We barely were aware the recession had actually ended before a new one had started. In contrast, there was the 1990s, where we had growth almost the entire period. The expansion started in March 1991 and ended in March 2001, a full 10 years of exuberance, which was sometimes irrational.

While there is no one single reason an expansion comes to an end and recession starts, what we do know is that businesses, households, and our elected officials view the world differently, depending on where the economy is going. Thus, while we may know how the different actors in our economic passion play interact, understanding their behavior requires a lot more than simply saying that people like to consume, businesses want to produce and sell their products, and politicians want to provide public services. It is the context of those decisions that we look at in understanding what should or should not be done.

Having developed a general understanding of all the major actors in this economic play and the importance of business cycles, the next step is to see how consumers, businesses and the government really work and how context affects their decisions, for better or worse. In Chapter 5, we start off by taking a look at households and their spending decisions.