I've seen a few posts on this site with people asking how to explain economics to an engineer, social sciences major, anyone without a business degree. Then my girlfriend (an engineer), after listening to all this hoopla about a recession, asked me: What are economics, how does the stock market work, what exactly is a recession?
With all the business guru's on this site - this is quite the gamble to post - but what the heck!
A couple warning's first:
This may not be 100% accurate
I use the "S" word a few times. You know the one. If the mod's don't like this, I can pull them.
It is supposed to be both entertaining and educational, enjoy!
It's LOOOOOOONG! Print it out and enjoy!
Ahhh... A little light conversation at 8:30am. Very nice... Do you have any questions about how a bike works? Or how to make chocolate chip pancakes? Or shit, why the sky is blue - even that is an easier question to answer!!!
I'll give it a shot - let's see if I stayed awake in those Econ classes!
Warning: This is a long read, and may not be 100% accurate, but if it was worth my time to write, it's worth your time to read!
The broad definition of a recession is 6 months of consecutive decline in the common market indicators - the most common being the GDP. The GDP or Gross Domestic Product is the value of all the shit manufactured or produced in this country, be it both products and services of American OR foreign companies (i.e. A Honda made in Ohio and sold in Nigeria effects the GDP and GNP). This is not to be confused with the GNP - the Gross National Product, the aggregate of all the shit manufactured by only American companies on U.S. soil AND abroad. (I.e. GM manufacturing a Buick in China, or Google setting up marketing offices in Iceland affects the GNP but not the GDP). Essentially, GDP is concerned with WHERE it was made, GNP is concerned with WHO made it. Back to this 6 month decline thing... Free market capitalism says that we should continually be buying more shit and more services perpetually. If you have too much shit to fit in your house - then you buy a bigger McMansion, further from work (thus resulting in the need to buy more shit, such as Gas, car parts, etc.). This is a theory which Bill Mckibbem (Deep Economy) argues. He states that more is not necessarily better, and that we should debit (that is charge) the GDP and GNP the environmental detriment an enterprise is causing (i.e. Charge $10 back to the GDP for each ton of carbon emissions created). Just some food for thought.
Now, in 2008, we have had some big buzz word problems. Sub Prime Mortgages. "Prime" is a set "good rate" which people with "good credit" can borrow at. Sub Prime is a higher interest rate (paid by the individual, not received by the individual - so BAD!). The original idea was that Sub Prime Mortgages will give people money who otherwise couldn't have had access to it... The problem is, nobody stopped to think that perhaps it is not good to lend people money who can't afford to pay it back! "Predatory Lenders" (i.e. Rock Financial), are known to "sell" people on larger mortgages then they can afford. When people can't pay back the mortgage, the bank which backed the mortgage takes back the house. The problem is, Banks are not in business of being land lords - they don't want these homes! So, when a whole shit-load of people default on their mortgage, the banks are hurt, which drives down their stock price. Banks also handout these nifty little things called credit cards! When you load up a credit card, and can't pay it off, the bank is liable - it's BEAUTIFUL! The problem is, the bank not only doesn't want your McMansion, it doesn't want all the bull shit you stuffed in it. So the stock price tanks even further. Wait... what exactly is a stock anyway?
Glad you asked... Stock prices are really a measure of consumer confidence (which, ironically, is another one of those "Market Indicators" I originally mentioned) which tied directly to a companies performance (and potential!). When people feel good about a company, they buy stock. When I say people - I really mean savvy investors. When savvy investors discover that Google is not only the most advanced word in Dubya's vocabulary, but also this insane computer company that is going to take over the world, they say, "shit, I wants to own me some of that!" Then the most basic economic principle of supply and demand kicks in. Since everyone wants to get them "some of that" - the price goes up! Any commodity is a good example of supply and demand - see oil for a perfect example... Another way a stock price can change is if the company issues more stock, or buy's stock back - this results in the same rules of supply and demand. Now, when those same Savvy Investors are holding onto all these bank stocks and mortgage house (lenders) stocks, and see that banks are having to cover for all these people who bought 3,000 sq. ft. homes, 90 minutes from their $30,000 a year jobs - they say, shit, this is gonna get ugly! SELL SELL SELL! Buy me some of them secure government bonds! So, the stock market goes down, and people buy more bonds...
Maybe you're asking why Uncle Sam doesn't step in to prevent all of this from happening... Actually, you probably weren't, but you should have been! First of all, in free market capitalism, the markets are self-regulating, meaning that it's not the government's role to step in. But in our capitalism, Uncle Sam still plays a role. It's actually not Uncle Sam - it's Uncle Ben. Ben Bernanke (the Federal Reserve Chairman) is the poor sap in charge of deciding what to do with the Federal Funds rate and how much money to print. Banks have to keep a certain amount of cold hard cash in a vault (a percentage - say 10%, of all the money they are holding for people). If banks had to actually keep 100% of the money given to them as cash, the system wouldn't work, because the Bank wouldn't be able to invest and make money! Back to the Federal Funds Rate... When banks need more money, Uncle Sam tells them to borrow from each other. If one bank has more than the 10% cash needed, they can lend to banks with less than the 10% cash needed. The amount of interest charged by the lending bank is loosely set by the Federal Funds Rate. If Uncle Ben wants to make it easier for banks to get money, he lowers the rate. Sometimes banks can say, "Screw that other bank! I want to borrow from you Uncle Sam!". This can be done, but is costs more money (higher interest rate) - this is called the "discount rate". I know, it's a pretty deceiving thing to call borrowing money at a higher interest rate, that Uncle Sam can be pretty sneaky! I mentioned that Ben can also print more money - a way to infuse money into the economy. My brother always said, I don't get it, if we have a deficit and need more money, why don't we just print more? Well, it's not that cut and dry. If we print more money, there is more supply, which means the cost (or value goes down). The global economy used to rely on the "gold standard" - this meant that economies needed to have hard, tangible, gold in a reserve to back all of the printed money. This is no longer the case. Economies and the value of currencies are now essentially based on the goodwill of the global economy. That is, the trust and faith that a government can support its currency through bonds and taxes.
So what is a bond? Aside from a shrewd English secret agent, they are also a way of raising money. Corporations can raise money in two ways - Stocks (selling actual "shares" of your company), and Bonds (Borrowing money, with the promise to pay it back with interest). Corporate bonds are ranked according to how likely it is that a company will be able to pay you back. If a bond rating agency doesn't think a company will be able to pay back the bond you bought, they say, "Man, that bond is Junk" and label it a junk bond. Junk bonds are "cheaper" to buy, so there is more potential reward to go along with your additional risk. Bonds are commonly issued by governments to raise money (since they can't sell "shares"). Bonds can be local (city bonds) all the way up to Federal Bonds (Uncle Sam). You can usually be pretty confident that Uncle Sam can pay you back. All he has to do is print more money -> which then results in the devaluation of our currency, which is a whole other ball of wax!
OK, uh, what was your original question? Oh yeah, recessions. Recessions are very finicky things. First of all they are very loosely defined. As I mentioned, the generally accepted definition is "negative growth" (what?), for 2 quarters. However, the NBER (National Bureau of Economic Research), is the U.S. governmental organization that actually defines when we are in a recession. They look at more than just GDP numbers, they also take into consideration: employment, corporate profits, consumer confidence, investment, etc. For the sake of sanity, just think about all of this as the GDP - since they are all complimentary (meaning when one goes up, the others usually do to - or in this case, when one goes down...).
Now that you are more confused then when we started - I'm going to throw another buzz word into the mix. The deficit - well, it's really "the deficits" (plural). When Ross Perot said, "Let's talk about the deficit", he was referring to the budget deficit. This will help answer your question about how we're paying hundreds of billions (some estimate the true cost to be trillions) of dollars on this war we're in. Well, it's easy - Uncle Sam says, "Just put it on the card". When the Government spends more money than it makes, we have a budget deficit. Since the world economy relies on America's gluttonous consumption of, well, everything, the deficit does not cause our currency to crash (but it does "hurt" it a little - see "goodwill"). OK, that's the budget deficit (the opposite is budget surplus - when the gov't makes MORE than it spends), but what's the other deficit? Good question! The other commonly discussed deficit is the trade deficit. The trade deficit is the net exports of a country. Uh, ok, that tells me a lot... Let me break it down. The net exports are simply all the shit we export minus all the shit we import. In the US, we have ran a trade deficit since 1991. This means we have imported more than we have exported. When you consider all the outsourcing of manufacturing to lower cost countries, and the amount of cheap crap we bring in, it's not hard to imagine how we got to this trade deficit.
So that's global economics in a nutshell... It sure is confusing. To bring it all together and bring us back to where we started, I'll leave you with this automotive question which puts the global economy in perspective. "Domestic Content" refers to the % of parts and labor which are from the U.S.
What is more patriotic, what supports the US economy more?
Buying a Ford Fusion made with a 30% domestic (US) content and assembled in Mexico
Buying a Toyota Camry made with 75% domestic (US) content and assembled in Georgetown, KY, USA
It's all a matter of perspective!