Basic Economics

How many times have you heard someone respond to a comment or a statement by saying, “that is economics 101?” Ironically, there are not that many schools that require students to take basic economics, and few students take it as an elective. The upshot is that few university educated people have a basic understanding of economics, which is a sad and unfortunate state of affairs.

Basic Economics 101Perhaps students have backed away because economics has long been called “the dismal science.” Victorian historian Thomas Carlyle coined the derogatory phrase in the 19th century in response to late 18th century writings of The Reverend Thomas Robert Malthus, who grimly predicted that starvation would result as projected population growth exceeded the rate of increase in the food supply. Interestingly enough, economists should be proud of the derogatory phrase because Caryle’s true dislike of economics was that its practitioners at the time (John Stuart Mill and Harriet Martineau) were in support for black emancipation and the ending of slavery:  Economics, in his opinion, was “quite [an] abject and distressing…dismal science…led by sacred cause of Black Emancipation.” Nevertheless, the derogatory aspect of the phrase and not its emancipatory underpinnings has stuck with us.

Though most students are scared away from taking economics, it seems that even when they do take economics, most learn very little because it is so poorly taught. Robert F. Frank, in “Economic View; Dismal Science, Dismally Taught,” points out that “Studies have shown that when students are tested about their knowledge of basic economic principles six months after completing an introductory economics course, they score no better, on average, than those who never took the course.” He suggests that professors try to teach their students far too much, bombarding them with hundreds of concepts embedded in complex equations and graphs, and more troubling still, these professors might not have mastered some of the basic concepts themselves. He goes on to add that “given the importance of the economic choices we confront, both as individuals and as a society, more effective economics training would yield enormous dividends.” Agreed.

It is unfortunate that many us do not attempt to learn basic economics and that when we do, it is so poorly taught. If more people had a rudimentary knowledge of economics, the world would be a better place. For example, the next time you hear a politician tell you he is going to create good paying jobs, boot him out of office because he is lying to you. The number of good paying jobs grows when a businesses in the private sector can make money on a product or service that is needed by the public. There is nothing wrong with a business making money. A business that is not making money would not hire new employees. Jobs are destroyed by an intrusive government that over regulates, cajoles, demeans and taxes the private sector. Eventually the government, who is ‘fighting’ for your interest, chases the business away, perhaps off shore, and the unemployment rate goes up. Just look to the State of Michigan for an example how this works.

Economics affects our daily lives in numerous subtle ways. Since it is under taught in schools, often avoided by students and generally misunderstood, we wish to offer a cursory review of some economic fundamentals, in the following order:

  1. History of Economics
  2. Micro Economics
  3. Macro Economics
  4. Impact of Economic Change on Currency Evaluation


History of Economics

As civilization began evolving, first in Mesopotamia and later in Greece and Rome, trade began to develop between the different city state neighbors. What might have been plentiful and common in one state was in short supply or not available in another state.  First came barter, often cumbersome and time consuming, and then came the concept of money, as a medium of exchange to pay for goods and services. Early economic thought was probably confined to pragmatic issues, such as the proper value for different commodities or items, the type of money needed to finalize a trade, what new items might be manufactured and traded, and how to transport different items.

Following the Roman Empire, the decades gave way to centuries and countries evolved, first as agrarian producers, a life of subsistence, then followed by the gradual movement toward mercantilism. Wealth was measured by the accumulation of gold and silver. If there were no precious metals in your country, the successful countries would manufacture goods and export those goods for sale to other countries. The exporting countries would collect precious metals for sales of its wares, restrict imports so they would not have to spend any of their metals, and in this way accumulate wealth.

The shortage of gold in Europe prompted nations to explore and conquer the world in search for precious metals. Mercantilism was a concept that became popular in the 16th century. The seeds of economic nationalism and modern capitalism came in part from this concept which leads to exploration in the Americas and the search for gold and silver.

Adam Smith's The Wealth of NationsEconomics, as a separate discipline, began with the publishing of Adam Smith’s “The Wealth of Nations” in 1776. In this book, Smith claimed that land, labor, and capital were the three major ingredients for the creation of wealth. He believed that economies would be self regulated, free of government interference. An ‘invisible hand’ would guide individuals to make the right decision, and each individual, working in his own self interest, would best serve society. This laissez-faire concept, absent of government or private interference, is hardly today’s way when we have massive government regulations and bail outs for both individuals and corporations. Other early economists accepted some of Adam Smith’s ideas and developed their own additional concepts. David Ricardo contended there was a conflict between the interest of land owner, labor, and capital. Population increases would increase the value of land, and rent and hold down the payment to labor. It looks like class war fare and concern with the ‘unfair’ distribution of income have been around for hundreds of years. This led to the concept, proposed by John Stuart Mill, that the classical economic model was quite effective with the allocation of resources, but was unfair in the distribution of income, making it necessary for society (government) to intervene. As the world economies grew during the 18th and 19th centuries, and as some of the rich began to accumulate, an economic theory was developed to redistribute that wealth. In 1867 Karl Marx wrote Das Kapital. In this book Marx asserted that labor was the only creator of wealth, and laborers were being exploited by capital. An earlier economist, Thomas Robert Malthus had proposed that population grew geometrically and faster than increased food production. Consequently the ample supply of labor combined with high food prices meant that workers remained trapped, living at a substance level. This economic rational that labor, not capital, was the source of value, gave birth to the communist movement.

The economic turbulence following World War One in the 1920’s spawned the growth of two movements that dominated most of the remainder of the 20th century. The Bolshevik revolution in Russia deposed the Czars, and afforded Lenin, in theory, a chance to test the theories of Marx. In Germany, oppressive war reparations combined with runaway inflation, helped usher in Hitler and his National Socialist Party.

John Maynard KeynesConcurrent with the collapse of the global economy, the depression and the consequent high employment was the arrival of John Maynard Keynes, and his theory of economics. Politicians knew their terms in office would be cut short unless they did something to reduce the unemployment, so they quickly tried some of Keynes’ ideas. It was his contention that an economy, left alone, would have unsatisfactorily high unemployment. Demand for goods and services were small because people saved too much money. It was therefore up to the federal government, to stimulate the economy by spending more money. So a spending program was launched by the Federal government, with public works programs that hired the unemployed and bolstered the economy.

Much has been written about Keynesian economics over the years. In the 1930’s it solved neither the depression nor the unemployment problems, but it gave the government an excuse to spend money, gave the appearance they were doing something and rewarded their constituents with pet projects. Over the years, governments have become very proficient spenders.

Today the disciples of Keynes continue to have a big influence over government activities in the Western world. Stimulating the economy with huge amounts of deficit spending is the centerpiece for the recovery of economies in the developed world after the 2008 recession. The massive spending and the consequent liquidity has indeed bolstered the economies, but it remains to be seen if this will be a permanent solution.

Milton FriedmanThere are many other schools of economics, but one worth noting is the Chicago School, as taught by Milton Friedman. In a fashion, his theories counter balanced the Keynesian model which expanded the size and influence of the Federal government. Friedman contended that free markets work things out, given time, if left alone. Markets are inherently stable, and become unbalanced when there is government intervention which can lead to a recession. Money supply was another concern of the Chicago school. A reduction in the money supply, which Friedman claimed was one of the causes of the prolonged depression in the 1930’s, must be avoided. It is interesting to note that the current Federal Reserve Chairman, Ben Bernanke, subscribes to the monetarist philosophy and has provided ample liquidity during the latest recession.

The study of economics is generally broken down into micro and macroeconomics.

Micro Economics

Microeconomics is the study of individual actions or behavior that leads to a decision that results in economic activity. Is there, for example, a price or a rate of credit which would motivate you to go buy a new car? At what price will you stop buying steak at the super market and switch to chicken or hamburger? If the price of gasoline goes sharply higher, will you reduce the amount of driving? Stay home? Take a bus instead or cancel a trip?

If you are a laborer with multiple skills, at what wage differential do you stop being a mechanic, and instead drive a tractor trailer? Is there a wage where you would give up your job as an assembly worker and become a member of management? You are a farmer, and you can produce wheat or barley on your land. How do you decide which it will be?

Now switch perspectives and become a manufacturer. How do you assess the market for your potential products? If the price of one product is at a level where you make a marginal profit do you commence production? Should you produce too many of these items, will this run the price down? What will happen to the demand for your products if the value of your currency changes dramatically? A lower currency might enable you to compete in the export markets allowing you to expand production and start a second shift, but a higher currency would make imports cheaper and might put you out of business.

These are all microeconomic issues, many coming under the broad category of supply and demand. This can get quite complicated. Suppose for example, a union organizes your plant, and threatens a strike unless the wages are raised. You raise the wages and lose market share because you now have to raise prices. Your currency goes up and now you can no longer compete anywhere with foreign produced products. Now, do you close your plant, lay off the workers, and start producing at a factory overseas?

Years ago when studying economics at the universities, I had the feeling that economists had a very special knack for making things needlessly complicated. The concept of supply and demand can be expanded to incorporate all sorts of theories. They assume consumers are rational, price is determined by equilibrium between supply and demand, and people will buy more when the price is cheaper, that there is a marginal price where people stop buying one product and switch to another. From experience, we all have examples of irrational consumer activity, perhaps motivated by emotion rather than rational choice.

Microeconomics can also apply to actions by firms, agricultural economics, labor organizations and economics, and managerial policy. Governments, with their welfare policies, become part of the distribution of goods and services. How governments chose to spend tax revenues, for what products and services is another micro issue.

As forex traders, our concern is the impact of economic decisions and activity. How does micro activity influence the relative value of currencies? For the most part, changes in the relative supply and demand of products and services are subtle and gradual. There is, however, nothing subtle about the impact of macroeconomics on currency values.

Macro Economics

Macroeconomics is an overview of economic activity. While microeconomics is concerned with millions of decisions which alter the price or economic activity, macro studies the overview of economic activity and the institutions involved. In a fashion, macro economic activity can be viewed as action by a few, usually working within a government organization, with the ability to impact the lives of many. This is not to imply that most government organizations are working with malevolent intentions, but there will often be a heated debate about the appropriate policies. Macroeconomics focuses on national compilations of employment, income and output, the inflation rate, the growth rate and many other aggregate barometers of economic activity.

Of cardinal importance to a government is how to create the proper mixture of freedom, capital, labor, and monetary rewards which results in an atmosphere that stimulates economic growth. Economic growth then results in the creation of jobs, thereby increasing the per capita income and the wealth of the country, and of course, tax revenue to fill the public coffers.

Sounds simple right? Well you have some dynamic concepts and groups all competing to get their ‘fair share.’ How much freedom can an individual or corporate entity have?  What is labor to be paid? What percentage will profits be taxed? If taxes are too high on profits, then the capital will not be available to run or expand the business. If the company succeeds then the legacy of Karl Marx, fanning distrust and class envy, reemerges. You can see there must be the right balance for the economy to grow. Now an abundance of empty factories dot the scenery of the US Midwest like statues, symbols of bad management, poor government policies, and trade union greed.

Though economic growth is a desired objective, achieving the proper amount of growth is not easy. If the growth rate is too slow, then increased unemployment looms as a possibility.  Excessive growth can cause inflation and one of those nasty bubbles. A bubble is a period of exceptional growth in a segment of the economy, such as housing, that causes rapid appreciation of prices, overbuilding, and is then followed by a crash in the prices.

Some economists think that a steady 3% rate of Gross National Product growth is about right to absorb a gradually expanding workforce and maintain close to full employment.  With our current unemployment rate over 9.5%, however, several years of 5% growth would be needed to get the unemployment rate under 6%.

Economies have always had economic or business cycles, as the rate business activity changes. There are a myriad of potential causes for the business cycle, and in global markets, such as we now have, the cause may be from miles away. At one time, for example, almost all televisions were made in the United States. You had the choice of Philco, Crosley, Zenith, RCA and many others. A few of the names may remain but they are no longer made in the United States, and probably not by the same companies.

Business cycles remain a problem for governments, politicians, and their economists who would love to tame the unruly and unpredictable business cycle. The government’s objective is to stabilize output over an extended period of time with monetary, fiscal, and public policies. During periods of subdued activity, the government will have the central bankers keep interest rates low. Reserve requirements of the bankers are low, so they have more money to lend. To encourage business to become more productive and efficient, tax credits, which reduce the amount of tax the business pays the government, may be written into the tax code. If an investment in new equipment makes a company more competitive, opens export markets and results in the hiring of new employees, the government may give that business an accelerated rate of depreciation on the new equipment purchases.

In an effort to stimulate consumer demand, government subsidies may be granted to buy the deal of the day. One of the recent examples of this is the tax credits given to ‘first time buyers’ of real estate. A tax credit, which is a reduction in the amount of tax you are required to pay, is a good way to stimulate buying in the real estate market.  Like most things in the real world, however, there are unintended consequences. The building boom of the first part of the 2000 decade resulted in a glut of unsold property, which led to declining prices, causing a major recession, which led to foreclosures, and further price reductions. By artificially stimulating demand for housing units this encourages more unneeded new construction, and keeps housing prices from falling further to clearance prices where the inventories would be reduced. Granted, keeping housing prices from falling certainly helps banks from accumulating more bad loans, and the home owners who are marginally solvent, but it merely postpones the day, and perhaps the level where prices will bottom.

These policies are used during times when the economy needs to be stimulated, after a recession or during times when curtailed activity threatens deflation. During times when business activity is rapidly expanding the central bankers will be more concerned with slowing the rate of growth. Interest rates will go up, bank lending requirements would customarily tighten (although they were purposely loose during the housing boom of the past decade), and the central bankers would limit the money supply. All these steps would be taken to curtail the rate of growth, hoping to avoid those nasty bubbles that hurt lots of people when they break. These actions which, are usually coordinated by the Central Banker, called the Federal Reserve in the United States, are monetary policies.  They increase or decrease the cost and supply of money, depending on their assessment of the status of the business cycle. Do they want activity to increase or decrease?

Fiscal policies are also used to stimulate or slow business activity. Fiscal policies are decisions made, and laws or regulations passed, usually by the central government on matters of taxation and spending. For example, the central government may intentionally embark on a plan of deficit spending intended to stimulate the economy. Though these plans may have theoretical appeal, implementation is subject to corruption, malfeasance, and just plain waste. There are numerous examples of US members of Congress, because of their ability to expropriate money out of the Federal cash register, able to return it home to their own district, awarding the money to friends and supporters for their most favored projects in their district. They build bridges to no where; lavish airports like the one in Johnstown, Pennsylvania, the late John Murtha’s district, that may have one sparsely used flight per day. In the state of West Virginia, numerous roads, civic buildings, nursing homes and bridges are named after Sen. Harry Byrd, because he was able to secure Federal money for local projects. Yes, federal spending does increase economic activity in specific areas and certainly benefits those who directly receive it, but this is not the efficient allocation of resources as envisioned by Adam Smith or Milton Friedman. Milton Friedman has argued cogently on the fallacy that goverment spending and deficits stimulate the economy, pointing out that government can only get the dollars it spends in one of three ways: taxing, borrowing, or creating new money. Taxing and borrowing take from the economy, essentially canceling out the effects of the spending or worse, and creating new money amounts to monetary stimulus, which could boost economic activity whether the new money is spent by government or by the private sector.

The following chart from the Wall Street Journal shows the shocking and unsustainable spending explosion. US government spending has grown seven times as much in real terms as median household income over the last 40 years!

Employment and compensation in the public sector have continued to increase while the private sector has taken the pain. Moreover, politicians in the federal government, calling it economic stimulus, borrow money, and give this money to their supporters, payment for past and future votes. Sometime at a later date taxes or fees will be raised to pay off the debt.

Tax policy, rates, and regulations are other tools the government can use to stimulate or slow the economy. With each change, however, comes a debate. The classical economists argue that lowering taxes and letting the individual decide what to do with his earnings is the most efficient way. Whether he spends, saves or invests, it is his decision. Lower tax rates do stimulate the economy and result in economic growth, but as Bill Clinton once commented in Buffalo, the individual does not make the right decisions with the money, so the federal government will keep some of their money and do the right thing with it.

Problems arise with the laissez-faire free market approach to taxation and government policy because it is claimed to be unfair. Some citizens, for a number of reasons, are not as successful as others. There is class envy of those who have been the winners in life’s game of lotto. The theories of Karl Marx and Vladimir Lenin are revived, distilled, camouflaged, and repackaged. The successful are then punished with progressive tax rates which often exceed 50% of their income. The function of the central government is to redistribute the money from those who are successful to those less fortunate, provided of course, they will vote in mass for the governing party. The redistribution of money from the successful to the less successful was never the intention of the founding fathers, but has become the way politicians use tax policy to give money and favors, paving the way for their reelection.

As you can see both monetary and fiscal policy can be used to influence economic activity, but both policy approaches have their limitations. The biggest problem seems to be problems with the allocations of funds and stimulants, which are not altruistically appropriated for the good of the general society, but rather to the friends and supporters of the politicians.

Impact of Economic Change on Currency Evaluation

The value of a currency, as we have previously mentioned, is always in relationship to something else. In forex, it is in relationship to another currency, hence the trading of currency pairs. The price of the pair, therefore, depends upon changes in two different economies. We are not only concerned with change as reported in an economic report, but how the trader perceives future changes will occur. This is important! How does the trader feel about the direction and strength of future economic changes?

An efficient market, in some ways, is one that has correctly discounted, or anticipated the future. Market surprises are not well received by the trader and usually result in erratic price movements. Since pairs are involved, the market is required to discount the current status and future direction of two economies, a more difficult assignment.

In addition to economic factors and the anticipated changes in these factors, there are two other factors that may influence the value of a pair. The first, of lesser importance, is the influence of cross currency trading. The relationship between the USD and the CAD, because of the close geography, and importance as trading partners, may influence the trade of the CAD versus the pound in cross currency valuation. Heavy selling of the CAD versus the USD may depress the CAD and weaken it against the pound. The strengthening of the pound is merely the result of heavy selling in the CAD versus the USD.

The other factor, and this is a very big one, is the current speculative attitude toward risk. Traders are willing to assume more risk when things are going well, but put some stormy forecasts in the sky and traders become very defensive with their money. We will examine this in greater detail later.

So to determine the current value of a pair we need to know all economic data pertinent to both currencies. It is like having a snap shot of the current well being of the economy.  That, however, is not enough because the input to currency values are many, and the traders are always trying to peer down the road or around the corner in an effort to get an edge on the future value of a currency pair.

Some economic reports are leading indicators, because they are the first to move higher or lower when a trend is changing. An example of leading indicators would be durable goods orders, which are orders for items that take time to construct, like an airplane or an oil tanker, and will be needed for future use.

Surveys are taken in most countries which attempt to determine the level of future economic activity. These may be consumer spending surveys or surveys of purchasing agents for manufacturing companies, or perhaps a poll of consumer confidence. The results of this data provides clues to all the participants in the forex market, what might be the level of future business activity. Our current level of activity, and it’s trend is useful information, helping to determine where we might be headed.

Reaction to the various reports will depend upon what had been anticipated, where in the phase of the current business cycle the economy is, and the status of the other countries economy in the currency pair. Should the data show a rapid expansion of activity, this might be a constructively received report, if the economy is in the early recovery stage. Response might be just the opposite if expansionary activity is reported after a period of rapid expansion. If there are reports in two different countries on the same day, this compound the hazards and the trading opportunities.

With the ample leverage in forex trading, and the multiplicity of factors traders use to determine the price, there might be the right price, but for only a few minutes before there is more news, or traders want to get in, or out of the market. This moves the market to a different level. You have to assimilate and react to the information available, trying to capture some of the move. Yes a pair may, over time, move 500 pips, but the back and forth interim moves may be 2500 pips. Good luck. A moving target gives you lots of opportunities.

Summary of Economic Influences

The study of fundamentals includes the collection and the interpretation of a lot of data.  In a broad sense we are dealing with macro economic events. All free market economics have business cycles. If we try to eliminate all the highs and the lows from a business cycle, the chances are we would then have an economy with only lows.

Yes we do live in a related global economy, but economies and countries are not the same. Differences may be the result of political philosophy or choices made by the population. If a country that has centralized government with high taxes and a multiplicity of centralized services, that country will likely have a slow growth rate. A change in the government’s economic goals and philosophy can have a drastic impact on a currencies value. Consider, for example, the impact of Hugo Chavez has had on the value of the Venezuelan Bolivar, which was recently devalued by 17 to 50%.

There are many other factors that can cause economies to differ.  Some countries have abundant natural resources which are needed by the world, such as oil.  Other countries have a high level of education that prepares their people to contribute in a complex computerized world.

There are so many factors that can influence the value of currency pairs, but there are a few things to remember:

  1. Why are we trading at this level? What do we know about the current level of economic activity?
  2. Is there any perception that macro economic changes will affect currency levels?
  3. How will the currency valuation change is the future, when responding to local and global change?


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