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Economics for Dummies


[Written 2012-07-29]
 
Like I did until early 2012, you may think, "Economics is boring, complicated, and best left to number crunching nerds with college degrees in the subject." Let's test that idea. 

Economics can not be realistically understood unless you consider all the ways it intersects with philosophy, politics, and even psychology. The video I linked to on the right gives an easy-to-understand overview of the two most popular schools of economic thought and debunks a couple myths.
 
The title of this article is Economics for Dummies so I'm simplifying here and even generalizing some. For example, there are many more than just two schools of economic thought. We are going to focus here on two of the most popular and diametrically opposed, Austrian and Keynesian. Also, in every school of economic thought, there are variations. Not every Keynesian would handle the current crisis in the same exact way and nor would every economist who follows the Austrian school of thought. I also want to admit I'm biased toward Austrian Economics.  

Austrian Economics is the oldest school of economics in recorded history. For awhile now it has been eclipsed by Keynesian Economics. When the 2008 financial crisis hit, there was a resurgence of interest because it was primarily Austrian-school economists who had predicted the event with uncanny accuracy. People wondered, "How did these guys know when so many others did not?"

The most popular opposing school of economic thought, based on Maynard Keynes, believes that when unemployment is high, the government needs to pump money into the economy and when inflation is high, the government needs to pull money out of the economy. Unfortunately for followers of Keynes, in the 1970s when we had high unemployment and high inflation at the same time, there was no logical solution possible based on Keynesian principles. You can't inject money into the economy and pull it out at the same time. For many, this caused a loss of confidence in the Keynes school of economic thought. 

The loss of confidence in Keynesian Economics was short lived, however, because in a recession or depression people do not want to hear "Stop spending" and "Be patient, this is necessary pain, the market will adjust and slowly recover". People prefer a quick fix and would much rather hear their government is doing something, acting like a hero, and handing out money. When times are tough, who is going to argue with free money? And, in the case of interest rates, cheap money? Most politicians will prefer this route because it gets them popularity with the masses and we must not forget they get to pick where the money goes, which means time to enrich the politician's favorite CEOs. Back to where the money came from: It's easy to see the money as "free" when the Federal Reserve can print and borrow, so that people do not feel the immediate pain of this money being taken from their pockets, and they certainly don't relate the resulting inflation to said printing.

The Austrian answer is: The boom and bust cycles of the magnitude we have been seeing are not a natural feature of the market economy, but are caused by government interventions in the economy. The economy needs breathing room to liquidate unsound investments, trim the fat, start fresh, allow for competition to rise, etc. 

Keynesians predicted when WW2 was over that the drop in government spending would mean falling into the worst depression ever. This did not happen. The Austrian-school economists said no, the market will adjust. It turned out 1946 was the single most productive year for the US ecomomy in all of our history. 

The economy more or less adjusts to shocks on its own. One thing that is difficult to adjust to is when it is attacked from within by a central bank. The Federal Reserve is such a bank. It has the monopoly power to manage money. The goal of the Fed is to regulate how money flows in our nation in order to stabilize the economy.
 
A few examples

There was a depression in 1920 to 1921 that is rarely mentioned. In 1920 there was double digit unemployment, production was down, etc. Woodrow Wilson and Harding did nothing. The recovery happened on its own in roughly a year. This is in spite of the Federal Reserve being established in 1913.
 
During the 1999 to 2001 recession, housing values and new buys began rising. Normally, during a recession, we would have a housing slump.  This rise in buys and valuation was caused by the Fed pushing interest rates down instead of allowing the market to correct itself. So people dove into the housing market based on illusionary data.

In 2001 we were slowly recovering from the Dot Com bust. Look at how Greenspan (Federal Reserve Chairman) lowered interest rates eleven times that year. One might say, "Yay that's a good thing! What could be wrong with low interest rates?" The problem is that low interest rates have far reaching consequences for the economy. They lead investors to make decisions they would not have made otherwise. There are particular kinds of investment outlets that are sensitive to interest rate changes that now investors are more likely to invest in when the economy would normally be being saying to investors, "No. Don't invest in this. Bad investment." When you interfere with these signals to entrepreneurs, it creates a lot of white noise, obscuring truth, and causing them to invest their money in unsustainable paths. In particular, consumers were misled to get way too involved in housing. 







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