Economics is one the most powerful tools we have for understanding the world around us and creating good policy, despite its many shortcomings. Unfortunately few people have the opportunity to learn its fundamentals. I’d like to share what I believe are the basic lessons of economics that every concerned citizen should know. I’ll talk about the two basic disciplines in economics: micro and macro, and leave the topic of the international economy for part 2.

Microeconomics is basically the study of individual markets. There are a few core concepts from this field that most people are probably familiar with. The first is self interest, the idea that we can expect people to make decisions that are beneficial to them. It’s a simple concept with profound consequences. The next is opportunity cost, which is the idea that everything has a cost associated with the alternative that got passed up. Even doing nothing has an opportunity cost because we lose what might have been done. The third important concept is the law of diminishing returns, which teaches us that a little may be good, but a lot isn’t necessarily better. Buying one ice cream cone brings us a lot of happiness and buying a second might bring a little more, but each additional one we buy brings us less benefit until number 3, 4, or 10 just isn’t worth it – that’s diminishing returns. Finally, microeconomics teaches us about supply, demand, and prices. Simply stated, higher prices make more people interested in supplying and less interested in buying, and prices are basically determined by the willingness of people to produce interacting with the willingness of people to consume. So that’s it, a semester of microeconomics is one paragraph – at least the part that I believe every American really needs to know.

Next we have macroeconomics, which scares people off quickly with talk of GDP, inflation, exchange rates, employment, monetary policy, business cycles and many more confusing concepts. Give me a few minutes and hopefully you won’t be nearly as scared. As a broad oversimplification, people often talk about macroeconomics either in terms of classical economics which focuses on long-term output, or in terms of the short run based on what’s called Keynesian economics. Much of the debate in modern economic policy is often between those focusing on either classical or Keynesian ideas – which I personally think is a wasted argument since they teach us about different things and aren’t mutually exclusive. So, let me take a moment to describe the fundamentals of what each set of ideas teaches us. But first I’d like to explain the all important concept of GDP.
Gross domestic product (GDP) is the sum value of all the goods and services produced in a country. This is also called the country’s output. It is important because it is also the total income of the country – if you added up the annual income of everyone in this country it would be the same number as GDP. Just like a personal income, we have to decide how to use this “country income.” Part of it goes to the government, some of it is spent on domestic goods and services, some on foreign products, and some of it is invested or saved. When we spend more than we make we borrow money on the promise to pay it back later. Nothing is too cosmic about this concept when you keep it in simple terms that anyone with an income and expenses should understand. A recession is simply when GDP goes down (our income is falling), and the aggregate stock market is basically a reflection of our total ability to produce income – meaning everything comes back to GDP, our country’s income.

Classical economic theory basically tells us that long term economic output (GDP) is simply a function of our resources, generally categorized as land, labor, capital, and technology. These are the inputs necessary to produce anything of value. Theoretically, out total production in the long run should only change as these things change. This explains a lot about long term trends, but kind of ignores some major issues. One of the major critiques that led to Keynesian economics is that classical theory just talks about how things are produced, but doesn’t talk about consumption and the variations that happen in demand. For this reason, policy based in classical economics is often referred to as supply side economics. Proponents of this kind of policy basically focus on improving the economy by making it easier or more attractive for people to produce, since our income is based on total production.

So where do all the fluctuations in the economy come from? Land, labor, capital, and technology never really decrease in this country, so why does our production (GDP)? Here’s basically what happens. Some kind of shock enters the system: oil spikes in price, mortgages fail, terrorism strikes, or anything else that makes people start spending less money temporarily. All the producers realize that people on average will be spending less, so to make ends meet they produce less. This reduction in production means that less people are working; usually manifested in layoffs and an increase in unemployment. We still have the capacity to produce more, but we don’t because people are out of work. Classical economics kind of ignores this, because in the long run this should all return to equilibrium again once the unemployed find new jobs. Keynesian economics, though, teaches us that we can smooth these fluctuations through government intervention. Injecting money into the economy, either through government spending (or tax reductions) or looser monetary policy (which basically means lowering the interest rate and making it cheaper to borrow money), can keep the consumption up, and thus companies won’t reduce production and unemployment won’t increase. This influx of money (which has to be borrowed one way or another) only needs to be temporary and the economy should maintain its steady state. If we fail to lessen the shocks to the economy with borrowed money, the unemployment rate will likely remain high while those people go through the long process of finding another way they can work and produce in society – all the while we are missing out on the production that we could have had.

Many people argue about whether we should be focusing on supply side policies or government interventions, but we need both to have a secure and growing economy. Good economics demands that our long term policy focus on increases in capital and technology, which requires investment. Investment happens when we spend less than we make, meaning it makes sense to not run a deficit as a long term policy. When shocks to the system occur, as they inevitably will, it makes perfect sense to temporarily inject borrowed money into the economy to maintain stability. However, good policy demands that in times of economic expansion we shouldn’t borrow – spending on borrowed money causes demand to be artificially high and will greatly reduce our ability to smooth the economy in troubled times. If we are spending borrowed money then we must make more money the next year to pay it back, which is reasonable when we are in a recession and operating below our known capacity – but we can’t expect every year to always be better than the last. If we borrow money in a good year, and have a shock to the system the next, we not only have less income but also have to pay back our debts from the good years. That, I believe, is why we are having trouble averting the current financial crisis. We’ve been living beyond our means in good times for so long that we lost the ability to effectively smooth the troubled times.

So what does all this mean? In very simple terms, our nation’s economic policy should be the same as any prudent individual’s: Spend less than you make in good times, saving a little for the troubled times that inevitably occur. When our country spends more than they make during the good times, we lessen our ability to cushion the hard times. Economics can become extremely complicated and many can distort its principles to make us believe in some magic solution, but I believe it’s actually quite simple. I’m convinced that our inability to revitalize our economy has nothing to do with the last two years, but everything to do with the last few decades of spending more than we make – it’s that simple. This isn’t something you can blame on either political party; they both have done their fair share of overspending.

Some may try to convince you that our interaction in the international economy makes things more complicated and gives us more options and they’re right, but it still boils down to the fact that we can’t continually spend more than we make. Stay tuned for part 2 when I’ll discuss the implications of international trade.