Myth: Politicians Cause Economic Decline

The Word on the Street

There is an almost universal and constant complaint that political leaders (particularly the U.S. President) have destroyed the U.S. economy, and if there were a change in leadership things could immediately improve.

The Truth

A free-market system (like the one in U.S.), almost has a mind of its own, and cannot be directly controlled or manipulated. Such control is only possible in a socialistic economy. While there are some aspects of a free market economy that can be influenced by politicians, the market as a whole is controlled by each individual. It is controlled by you and by me.

(This post attempts to compress the critical points from many courses of economics and finance. All references refer to the economic system in place in the United States.)

Free Market?

A market is a place where goods and services may be exchanged. When economists speak of “free” markets, they mean that the prices and terms of exchange in the market are controlled exclusively by the forces of supply and demand. The more of a good that is demanded by the buyers, the higher the price it can be sold for, and vice-versa. Likewise, the more of a good is or can be supplied by producers, the lower the price of the good, and vice-versa. This is fairly intuitive; if your friend has 100 cookies and you want one, he may well give you one for free, but if he only has one cookie and you want, you may have to offer him a lot for it.

So, in a free market system, the prices of goods are dependant upon how much of a good is demanded, and how much can be produced. When you buy a gallon of milk, you create demand for milk and help drive the price up. When farmers have a good crop of corn, the supply increases and corn will be cheaper. Now, the influence of an individual is small relative to the size of the market (in the U.S., it’s millions and millions of people), but our individual buying habits collectively come together to determine how the economy operates.

So What Can They Do?

There are a few aspects of the economy that can be influenced by political policy. However, bear in mind that the actions listed here do not effect the economy in the same way that turning the wheel effects a car. A closer comparison would be to say that it is like steering a horse by dangling a carrot in front of it. Just because a certain action should have a certain effect does not mean that it always will; there may be stronger influences to affect the course of the economy. These tools simply apply pressure to the economy to try to stimulate it to move in certain directions.

Interest Rates

This is probably the most important and effective tool the government has for influencing the economy. The Federal Reserve board meets regularly to decide what the base interest rate for the country should be. The lower they set the rate, the cheaper money becomes. Interest rates on loans drop and money becomes easier to get. This causes spending to increase, which tends to push stock prices up and gives the economy a boost. This boost does not come without a price, though. With increased spending, inflation begins to become more of a problem. In the current economic slump, interest rates have been lowered to all time record lows in order to encourage spending and the issuance of mortgages.

Raising interest rates has the opposite effect. It makes money more expensive, puts pressure on people to reduce spending, which cuts into the earnings of companies and can depress stock prices. On the bright side, it makes it so that consumer deposit accounts (i.e. savings accounts) yield higher returns, and tends to tamp down on inflationary pressures. The Fed may soon be forced to raise rates in an attempt to curb rising inflation, but even should they do so, it is unlikely that the current inflation in the economy will subside completely. Raising the rates will likely slow the inflation rate, but not stop it in its tracks. This is because there are other forces at work (like the rising price of gas [caused by rising world-wide demand for oil and by speculative pressures]) that are causing inflation.

Trade Policy

This is a area that is also very important. Trade is a wonderful thing because it generates wealth for everyone involved. By trading goods and services, both parties can come out better off for the exchange. By maintaining free trade laws, the U.S. can import goods at a lower price than it could manufacture them for, and can export goods which it can produce cheaply. Thus everyone winds up buying at the lowest prices possible. By enforcing trade barriers, the price of foreign goods goes up in the U.S., and the quantity available in the U.S. declines. Think about how often you buy foreign products like Sony TVs, Honda cars, Chinese made toys, etc and you begin to understand the ramifications of impeding trade. The effect of barring trade can be huge.

Industry Support

This one has come into the limelight with the mortgage crisis. There are times when the government can step in to help an ailing industry. Lately, it has been mortgage lenders who have been the recipients of government aid. Government aid can come in many forms. The ethanol industry has been benefiting from governmental subsidies; basically, the government has been giving money to ethanol producers because they cannot yet produce ethanol profitably. Once (if) the ethanol industry becomes established, the subsidies will cease and an entire industry will have been born which could otherwise have never gotten off the ground.

Regulation

One of the government’s most visible roles in the economy is the establishment of regulatinos that companies must adhere to. Such regulations are usually intended to help protect the public interest. Because a company (and insurance company, for example) has more intimate knowledge of the products and services it provides, there is an opportunity for the company to exploit an ignorant consumer. Government regulation helps prevent this. Government regulation can also be used to protect the environment or other public concerns. Such regulation may hinder a company from realizing it’s maximum profitability potential, but protects those who otherwise might not be able to protect themselves.

Taxes

Of course changing how much people and companies pay in taxes also effects the economy. By reducing taxes, companies become more profitable and consumers find themselves able to purchase more. This helps promote growth in the economy, but can also pose a hindrance to government spending. A healthy balance must be maintained so that the economy does not overpay in taxes, and the government can still have enough funds to accomplish it’s purposes.

Who’s To Blame?

Everybody wants to blame someone else for the economic slump in the US, but really, we have only ourselves to blame. Companies that issued sub-prime loans should not have issued them, true, but those who took the loans should not have taken them because they could not afford them. Why are banks going under? Is it because borrowers are not paying their loans? Yes, in part. Borrowers should not have taken debt which they could not afford. But there is a second part to the story of bank failure, and the recent collapse of Bear Stearns (one of the premier Wall Street brokerage firms) illustrates the problem. Bear Stearns was in great financial condition, and still is. So why, then, was it sold to JP Morgan Chase? The answer: lack of cash. Bear Sterns has tons of assets, but it ran out of spendable cash to pay its own debts with. This is the same problem many of the banks are facing. Why are banks running out of cash? Part, as stated above, comes from delinquent loans. But the other part comes from a lack of personal savings. Banks get their money from their members. If members save $10 million in a bank, then the bank has $10 million to work with. With savings rates pitifully low over the past several years, banks have been running out of money, and without money in their coffers, the banks cannot meet all of their obligations and are forced out of business.

So What is to be Done?

The change in the economy must start inside every household in the country. All of us must take care of our personal finances. We must be careful spenders AND careful savers. We must save money and invest in stocks and bonds so that the banks will not go under and so the stock prices can rise. We must also spend money. It is critical that companies received revenue from sales, or they will go under.

How can we both spend and save? It is not easy, but a critical point in doing so is to be careful in what we purchase. Only purchase goods that you need, only purchase goods that are fairly priced, and, most importantly, only purchase goods that you can afford. It is past overspending that is killing the US economy, one family at a time. Spending in itself is not bad, but spending more than you have is catastrophic, and we are now realizing the full consequences of our habits.

Posted on 18 Aug 2008