PDF Summary:Naked Economics, by Charles J. Wheelan

Economics is the study of how we allocate resources—food, clothing, money, time, effort, and knowledge. Economists begin this study by examining incentives: the driving forces behind our decisions. By understanding how we respond to incentives and the psychological instincts that steer us, we can better understand how market forces work and how governments and firms can use incentives to foster a healthy economy.

In Naked Economics, bestselling author Charles Wheelan strips away the complexity from some of the most powerful theories in economics, allowing readers with little or no background in the subject to understand many of the field’s fundamental concepts. He concentrates on the logical pieces of how and why people behave in certain ways, how markets function, and how governments can design incentive systems that encourage healthy economies.

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Financial Markets Serve Four Needs

Financial markets satisfy four basic needs that people have in an economy:

1. They allow people to raise money, by either borrowing money (through, for example, banks or venture capitalists) or by selling assets (through the stock or bond market).
2. They allow people to store, protect, and profit from excess money. Throughout most of human history, if people had excess assets such as a bountiful harvest or hunt, they’d have to use them immediately or lose them to rot. Today, people can put excess income to use in the financial markets to protect it from theft and inflation.
3. They insure people against risk. Through insurance policies and futures contracts—in which commodities traders contract for a future price for their goods—financial markets allow people to protect their capital and assets against loss.
4. They allow people to speculate. People can bet on future price movements for just about anything: commodities, corporate earnings, federal interest rates, and so on. Unlike gambling, though, where bets are a zero-sum game (if you win, the house loses and vice versa) and the odds are stacked against the gambler, financial markets like the stock market are a positive-sum system where wealth begets more wealth, and where you can reasonably expect to make a living if you speculate wisely.

The Health of an Economy

In order to properly evaluate the strength of an economy, economists must first figure out how to measure economies. There are several markers of economic health that they look at, but the primary one is an economy’s gross domestic product, or GDP. GDP summarizes the value of all the goods and services an economy produces. It’s the number that people generally refer to when they talk about a country’s growth: If you say the U.S. grew 3 percent this year, what you mean is that the U.S. produced 3 percent more goods and services this year than it did last year.

In addition to GDP, there are some other numbers that economists often refer to in order to judge how an economy is faring. These include:

• Unemployment rate: This number measures the percentage of people who don’t have a job but are looking for one. In general, a lower unemployment rate indicates a stronger economy, because there are plenty of jobs to go around. However, a too-low unemployment rate indicates a lack of skilled workers, which can hold back an economy’s growth.
• Poverty rate: This number measures the percentage of a population living below a certain level of income. A high poverty rate typically indicates a poorly run economy.
• Gini coefficient: This number uses a scale of zero to 100 to measure income inequality. A score of zero indicates total equality, where every worker earns the same amount. A score of 100 indicates total inequality, where one worker earns all the income. By this measure, America has grown more unequal over time: In 1950, the country scored 37.9, while in 2007, it scored 45. Economies that are more equal tend to have longer-term stability.

How Do Recessions Happen?

Recessions are periods of time during which an economy’s GDP shrinks. They’re generally caused by a shock to the system—something unexpected and bad happening. Shocks might be the bursting of stock market or real estate bubbles (when exorbitant price increases are followed by sudden and devastating losses), a steep rise in oil prices, or a combination of such causes.

Because all parts of modern markets are interconnected, the failure of one part of the economy can quickly cause other parts to fail as well. For example, if your income suddenly drops because of a stock market correction, you will respond by spending less money. Your decreased spending makes other people’s income decrease, who then respond by also spending less money, which spreads the pain throughout more and more sectors of the market.

When this kind of slowdown reaches banks, the entire economy can quickly freeze up. When banks stop lending money because they fear people caught in a downward economic cycle can’t pay it back, businesses can’t operate. This is what happened during the financial crisis that began in 2007. Homeowners took on more debt than they could finance in order to pay for new homes, fueling a property bubble. When property prices fell, people unable to honor their loans found they couldn’t sell their homes for enough money to cover their outstanding mortgages, and the resulting wave of foreclosures devastated investment banks. When Lehman Brothers, a major investment bank, declared bankruptcy, the global financial market froze as panicked banks stopped lending people money.

Countering Recessions

To counter recessions, governments can change their fiscal policies or their monetary policies to encourage businesses to begin investing and consumers to start spending, so that the economy becomes self-sustaining again.

Fiscal policies: A government can encourage spending by injecting money into the economy, either by cutting taxes or by creating stimulus programs that put money directly into the hands of consumers and businesses.

Monetary policies: A government controls the supply of money in an economy by increasing or decreasing short-term interest rates. Cutting interest rates allows consumers to buy more things and allows firms to invest. Raising interest rates puts a brake on the economy by raising the cost of money itself, making it harder for individuals and businesses to borrow capital.

A government can decrease interest rates to heat up an economy, but it must be careful that it doesn't go too far and cause inflation—a continuous rise in prices. When interest rates are low, people borrow more money, and with more money running through an economy, prices for goods typically rise.

If, however, a government errs on the opposite end of the spectrum with interest rates that are too high, it can tip an economy into recession. When interest rates are high, borrowing money becomes expensive and people and firms stop taking out loans. Consequently, individuals stop spending money on big-ticket items, like homes, education, or home improvement projects, and businesses invest less and hire less, which decreases the number of jobs available.

International Economics

The concepts we’ve reviewed so far relate to how an economy functions in general, and typically within the borders of one particular country. We’ll now look at how people, firms, and governments of different countries can interact with each other globally in an international market, buying and selling not only goods and services but also currencies. We’ll then discuss how international trade can benefit standards of living throughout the world.

The international market operates similarly to domestic markets, except on a global scale. The global nature of the international market adds complexity to business transactions, not only because of the logistics of buying and selling goods and services from far-away regions, but also because different countries have different rules, regulations, taxes, and currencies.

Currencies

A currency is the unit of money a country uses to conduct its business. Different countries have different currencies—for example, the United States has the dollar, Mexico has the peso, and Japan has the yen. Each country also has its own governmental institutions that create and manage its currency.

A physical piece of currency is just a piece of paper or a coin, but it represents an amount of purchasing power that can be used for goods and services. To evaluate a currency’s purchasing power, economists determine how many goods and services it can purchase from a hypothetical “basket of goods” that includes a broad range of things for sale. Economists call comparing purchasing power across countries purchasing power parity (PPP). PPP can be an effective way of comparing the strength of different countries’ currencies.

Determining Exchange Rates

People can trade or sell currencies for other currencies. Currencies behave just like any other item that can be traded or sold—their values rise and fall according to the laws of supply and demand. The price at which you can purchase one currency using another currency is called the exchange rate.

Today, most economies have floating exchange rates. This means that currencies are traded on foreign exchange markets (similar to stock markets but for currencies) and their values fluctuate against each other based on what traders are willing to pay for them. So, if a firm wants to, for example, change its dollars into yen, it would use the foreign exchange market to trade its dollars for yen at a price set by the supply and demand of each currency in the market.

Strong and Weak Currencies

Currencies can strengthen or weaken against each other, reflecting which one is more valuable to traders at any given moment. For example, if last week, one dollar equaled one pound, but this week, two dollars equals one pound, then the dollar has weakened against the pound: Each dollar can buy fewer pounds (in this case, one dollar would only be able to buy half a pound). If, however, this week one dollar equals two pounds, then the dollar has strengthened: Each dollar can buy more pounds.

The strength or weakness of a country’s currency has direct effects on importers and exporters:

• A weak currency hurts importers and benefits exporters: If the dollar is weak and can buy fewer pounds, then Americans can buy fewer British products, priced in pounds (from American soil, British products are imports). However, British pounds can buy more American goods priced in dollars, so American exports benefit.
• A strong currency works in the opposite direction, helping importers and hurting exporters. If the dollar is strong and can buy more British pounds, then Americans can buy more British goods imported into America. Further, if British pounds can’t buy as many American dollars, then British people can buy fewer American goods exported from America.

Overall, a currency responds to supply-and-demand market forces: A country with a healthy economy will often have a strong currency, since a strong economy attracts investors who purchase that country’s currency in order to conduct business in and with the country. This increases demand for the currency, driving up its price.

Currencies also respond to governmental policies, such as interest rates. A government might adjust the strength of its currency in order to manufacture some short-term benefits, such as propping up their exporters by purposefully weakening their currency.

International Trade

To a large extent, the world is economically interdependent. Exports have increased from 8 percent of global GDP in 1950 to 25 percent today, meaning that countries are trading many more of their goods and services abroad. The increase in international trade is often called globalization. Overall, international trade makes all the countries involved richer and raises their standards of living, be they rich or poor to start with.

Trade Helps Poor Countries

International trade allows poor countries to escape poverty. In fact, for a poor country to become a rich country, it must engage in international trade; there has never been a country in modern history that developed without doing so.

International trade helps poor countries in several ways:

• Trade gives producers in poor countries access to markets in rich countries, where the majority of the world’s consumers live.
• Trade creates jobs: When firms export goods, they employ people to make those goods. Then, other people find work servicing the first set of people; businesses spring up to supply the exporters, feed their workers, and so on.
• Trade builds human capital: Foreign companies setting up businesses in poor countries bring new technology and training that increase the skill sets of the people they employ. Those skills can never be taken away, and they allow workers to get other jobs elsewhere if needed.

The Danger of Protectionism

Although the benefits to international trade are enormous overall, this isn't always true on an individual level. Sometimes, people lose their jobs due to economic or technological advances brought on by international trade and end up with a permanently lower standard of living. If this happens, people sometimes decide globalization is the source of their problems and rebel against it, demanding protectionist policies to shield themselves from foreign competitive pressures.

When a government institutes protectionist policies, it puts up barriers to trade. These can be in the form of taxes, tariffs, quotas, regulations, or sanctions. These barriers keep foreign goods and services out of a country, thereby protecting the country’s own industries from competition. However, domestic firms protected from competition have few incentives to innovate, increase productivity, or lower prices, and consequently, economies with many protectionist policies in place typically grow stagnant and expensive for consumers.