So what are these 10 main economic goals?
1. Inflation – avoiding or reducing it.
2. Unemployment – often reducing the level, but sometimes deliberately doing the opposite to cool down an over-heated economy.
3. Economic growth – usually increasing it.
4. The balance of payments – either balancing it or aiming for a small surplus.
5. The value of the currency – in the UK this means maintaining the value of the pound, in the USA the value of the dollar, and so forth.
6. Improving the allocation of resources – this often means moving towards a more competitive market-determined solution; but the government has its own agenda too, such as it may wish to increase resources to education, defence, or the National Health Service.
7. The distribution of income – this often means trying to make it more equal, or at least paying lip-service to this.
8. The standard of living – a high standard of living is preferred, so increasing the level is often a goal.
9. Taking care of the environment – this is a relatively new goal, but one that is rapidly increasing in importance.
10. Avoiding unnecessary and undesired fluctuations in the above nine points.
As a quiet bit of fun, take a couple of minutes and pretend you are the Prime Minister, President, or person in charge of your country, and to see what priority order you yourself would choose. Then look at “Why it is difficult to get it just right” below. Being in charge is not always an easy job!
How can government try to manage the economy?
In a market economy there are only two main ways: monetary policy (altering the supply of money or the rate of interest) and fiscal policy (altering the level or structure of taxation).
In the case of monetary policy, since 1997 the government in the UK lost the ability to directly alter the rate of interest when it gave authority to the Bank of England’s Monetary Policy Committee to do this, although it is represented on the Committee. The central goal of this Committee is inflation; it attempts to keep it within one per cent of the annual goal set by the Chancellor of the Exchequer. The other goals of government are not the concern of the Committee.
In the UK, fiscal policy is administered largely through the annual budget, in April each year. Such once-a-year changes do not provide a flexible policy tool, but the effects do come into play quickly, which is good.
Both these policies are used to alter the level of aggregate demand (the total level of private spending on consumption and investment, plus all government expenditure, including export earnings minus import leakages) in the desired direction, if the government wishes to depress the economy, it reduce aggregate demand which will depress the rate of inflation, increase the level of unemployment, and improve the balance of payments. The authorities can do this by increasing the level of taxation (fiscal policy) or the rate of interest (monetary policy). Both measures take money out of the economy: extra tax to pay means less discretionary spending is possible, whereas increasing the rate of interest means that repayments on many borrowings, including the important mortgage repayments, increase (which leaves less in the pocket for consumers to spend). It also means that firms wishing to borrow to expand or to fund the purchase of machinery etc.) find it will cost them more, so they postpone it wherever possible (reduced spending on investment).
Why it is difficult to get it just right
1. Information lags – we do not ever know where the economy actually is when a decision has to be made.
2. Information reliability – errors creep in; there never really is totally accurate information available. “Garbage in, garbage out” then applies.
3. Different policy measures have different time lags before they take full effect. This means that as policy changes some older measures probably have not fully worked through, the new measures kick in, and at varying speeds, so we tend to blunder along. Hopefully we are going in the right direction although this is not always certain until later on.
4. Some goals contradict, so that there is no way of “getting it right” anyway! As one example, under normal circumstances, if we increase the level of aggregate demand to lower unemployment it tends to increase the rate of inflation, which in turn tends to reduce exports and increase imports, worsening the balance of payments. It also increases output and tends to widen the distribution of income
5. We are not smart enough to get it right. As we are dealing with human beings and they have freedom to make new decisions and change, it is possible that we never will be. The historical record of what happens when we changed the rate of interest by half a percent may not apply next time.
The foreign sector: trade and investment
All the above was concerned with a domestic economy in isolation. In reality, no country is alone in the world and few wish to be isolated. There is a high economic price to be paid for isolation: slow growth, great inefficiency, and a low standard of living. Most countries choose to trade with others as a result.
Why do they do it? What are the gains from trade?
1. Comparative advantage – a country produces what it is good at (agricultural produce, light industrial goods, services such as banking and finance….) and sells these to the world. It then imports what it is not so good at from those countries which can produce the item more efficiently and cheaply. This explanation is the main reason for trade. If all countries were equally good at everything, why bother to trade? As a personal example, if you are extremely good at playing football and a rotten cook, it pays to earn a substantial income playing sport and eat out at restaurants or employ your own cook. Your comparative advantage is on the sports field not in the kitchen.
2. Economies of scale – if it is cheaper per item to produce in vast amounts, then countries can specialise in a few things and sell them to others in exchange for things that the other countries specialise in.
3. Variety – consumers in a country might enjoy some foreign products, import them, and sell stuff in return. Motorcar production in Europe springs to mind as a possible example as each country buys cars from the others.
4. Sheer absence of an item – it is difficult to grow bananas in Iceland or make refrigerators in the Saharan desert, so things that are lacking may be imported. Note that it is not impossible to do this, merely very expensive to do so, which means that this is often really a specific case of comparative advantage.
Despite the established benefits of trade, there seems to be a widespread instinct towards protecting the economy from foreign competition, i.e. protecting jobs and protecting the profit of domestic companies. Each individual sector would like to be protected, although it does not mind much if all other sectors are not. In fact, this would be the best outcome for the small protected part, as it would gain all the benefits of cheaper goods and services plus rapid economic growth, but without giving up a thing. Since the end of World War Two, economies have gradually opened up and reduced the level protection although not at a steady rate. The views of economists, pressure from politicians such as Margaret Thatcher and Ronald Reagan, negotiations via a series of meetings at the international level, and the widespread but not complete collapse of communism, have all played a part.
Globalisation is the ultimate stage of this process of opening up domestic economies by reducing protection, increasing foreign trade, and liberalising the flows of foreign investment. The world as a whole benefits from this; but there can be, and are, losses to some. At the national level, things get in the way of a perfect market solution, and the same is true of the world as a whole. While companies in major, powerful, and rich countries gain from investing in poor countries, the local people may suffer. The influx of foreign capital can easily damage or destroy the existing local industry and agriculture. It is a specific case of a poor market solution when faced with an extremely wide income distribution but it is now on the global scale – the market operates to supply what is demanded by those with the money to spend. Those with little or no money have little or no say in the pattern of consumption and, ultimately, in what people choose to produce in order to sell. So with globalisation some of the really poor countries and their peoples may lose out; many of those living in richer countries (including many of their poor) definitely gain; and the world as a whole is certainly better off.
Is globalisation then acceptable? Is it fair or just? This is an emotive issue in which morals, ethics, and values are often hotly debated. Those institutions that work to reduce protection and increase gobalisation, such as the World Trade Organisation, are often attacked verbally and their officials physically. The antagonists are people who hold strong, some would say extreme, views that globalisation hurts the poor and is simply all wrong. The protagonists say that the world as a whole benefits and most are better off. The reply to this is that some are definitely made worse off, they are already the weak, the poor, and the suffering and they are not compensated by the greedy and selfish winners. Some respond to this view that that is just the way the world is, and in addition, there is no going back. The reply to this response may well be unprintable.
It has to be stated that economics, and the workings of an economy, are amoral; morality, ethics and justice do not appear. We believe that the price mechanism, free trade, and ultimately globalisation produce a more efficient system, a higher standard of living, and faster economic growth which all work for the benefit of many. But it involves loosers too and these are too often the poorest amongst us and the least able to cope.
How do we measure the degree of interaction with other countries?
This is done in the balance of payments, an account that shows our financial dealings with the rest of the world. It was traditionally divided into two parts, the current account, which includes trade in goods (that we can see) and services (that we cannot look at as such); and the capital account, which roughly explained how the current account was financed. If imports exceed exports, a country either pays the difference by transferring foreign exchange or else borrows to cover this difference. (A popular exam question was to explain how the entire balance of payments could be described as in balance when there was a clear surplus or deficit in the current account; well you either pay the debt or still owe it!)
Since 1998 the UK has adopted a four part approach to the balance of payments but the distinction between current and capital account persists.
1. The current account: the export and import of goods and services + incomes flowing to and from abroad, earned by workers and also from investments.
2. The capital account: changes in the financial size of ownership of fixed assets and what migrants bring in and take out as they come and go.
3. The financial account: changes in the financial size of assets the UK residents buy abroad and foreign abroad buy in the UK.
4. The international investment position: the total stock of assets that UK residents own abroad and foreign residents own in the UK. The first three items are money flows, not stocks.
Which part of the balance of payments matters? All of it. We look at the part of the balance of payments that gives us the answer to whatever question we are interested in. Having said that, attention mostly focuses on the current account and changes in it, because it shows how well we are currently doing.
That’s it, economics in a nutshell. Warning! It is necessarily a limited explanation and misses out much; it is no more than a simplified, basic introduction to a complex and fascinating discipline. There are articles and whole books written about almost all the topics that were discussed here in a few sentences or words. If you believe that you have got what you wanted, then stop reading now! On the other hand, if you feel that you would like to go further and understand more, then you can download and read the book of notes that explains this article in much greater detail. It also provides diagrams to illustrate and help analyse the issues; it can be found at: http://www.kevinbucknall.com
Copyright © Kevin Bucknall, July 2007.