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In economic terms, anything used to reduce the downside of risk. In its most familiar form, insurance is provided through a policy purchased from an insurance company. But a fuller definition would also include, say, a financial security (or anything else) used to hedge, as well as assistance available in the event of disaster. It could even be provided by the government, in various ways, including welfare payments to sick or poor people and legal protection from creditors in the event of bankruptcy. Conventional insurance works by pooling the risks of many people (or firms, and so on), all of whom might claim but in practice only a few actually do. The cost of providing assistance to those that claim is spread over all the potential claimants, thus making the insurance affordable to all. Despite the enormous attraction of insurance, private markets in insurance often work badly, or not at all. Economists have identified three main reasons for this. * Private firms are unwilling to provide insurance if they are uncertain about the likely cost of providing sufficient cover, especially if it is potentially unlimited. * moral hazard means that people with insurance may take greater risks because they know they are protected, so the insurer may get a bigger bill than it bargained for. * Insurers are at risk of adverse selection. The people who are most likely to claim buy insurance, and those who are least likely to claim do not buy it. In this situation, setting a price for insurance that will generate enough premiums to cover all claims is tricky, if not impossible. Insurers have found ways of reducing the impact of these problems. For example, to counter adverse selection, they set higher health-insurance rates for people who smoke. To limit moral hazard, they offer reduced premiums to people who agree to pay the first so-many dollars or pounds of any claim. An efficient system of insurance, in its broadest sense, can contribute to economic growth by encouraging entrepreneurial risk taking and by enabling people to choose which risks they take and which they protect themselves against.
Industry:Economy
A vital contributor to economic growth. The big challenge for firms and governments is to make it happen more often. Although nobody is entirely sure why innovation takes place, new theories of endogenous growth try to model the innovation process, rather than just assume it happens for unexplained, exogenous reasons. The role of incentives seems to be particularly important. Although some innovations are the result of scientists and others engaged in the noble pursuit of know¬ledge, most, especially their commercial applications, are the result of entrepreneurs seeking profit. Joseph Schumpeter, a leading practitioner of Austrian economics, described this as a process of “creative destruction”. A firm innovates successfully and is rewarded with unusually high profits, which in turn encourages rivals to come up with a superior innovation. To encourage innovation, innovators must be allowed to make a decent profit, otherwise they will not incur the risk and expense of trying to come up with useful innovations. Most countries have patents and other laws protecting intellectual property, which allow innovators to enjoy a (usually temporary) monopoly over their innovation. Economists disagree over how long that protection should last, given the inefficiencies that result from any monopoly. For most of the second half of the 20th century, governments played a crucial role in funding and directing pure research and early-stage development. In the 1980s, however, legal changes in the United States started to reduce this role. One change aimed to move technological development out of the country’s state-financed national laboratories. Another allowed universities, not-for-profit research institutes and small businesses doing research under government contract to keep the technologies they had developed and to apply for patents in their own names. This appears to have contributed to a surge in innovation in the United States, as government researchers and university professors teamed up with outside firms, or started their own. Hoping for similar results, many other countries have followed suit. Is innovation all it is cracked up to be, or is it just change for change’s sake? A few years ago, Robert Solow, a Nobel prize-winning economist, observed that “you can see the computer age everywhere these days except in the productivity statistics”. Although new computer technology clearly had affected people and firms in visible and obvious ways, the slowdown in productivity growth that had afflicted the American economy since the 1970s did not appear to have been reversed. Believers in the new economy argued that the “Solow Paradox” no longer holds true; in the late 1990s, the computer revolution started to deliver the productivity growth long promised. Even so, this shows that innovation can take a long time to deliver the goods.
Industry:Economy
The oil that keeps the economy working smoothly. Economic efficiency is likely to be greatest when information is comprehensive, accurate and cheaply available. Many of the problems facing economies arise from people making decisions without all the information they need. One reason for the failure of the command economy is that government planners were not good at gathering and processing information. Adam Smith’s metaphor of the invisible hand is all about how, in many cases, free markets are much more efficient at processing information on the needs of all the participants in an economy than is the visible, and often dead, hand of state planners. Asymmetric information, when one party to a deal knows more than the other party, can be a serious source of inefficiency and market failure. Uncertainty can also impose large economic costs. The internet, by greatly increasing the availability and lowering the price of information, is helping to boost economic efficiency. But there are inefficiencies the internet will not be able to solve. Uncertainty will remain a huge source of economic inefficiency. Alas, potentially the most useful information, about what will happen in the future, is never available until it is too late.
Industry:Economy
The economic arteries and veins. Roads, ports, railways, airports, power lines, pipes and wires that enable people, goods, commodities, water, energy and information to move about efficiently. Increasingly, infrastructure is regarded as a crucial source of economic competitiveness. Investment in infrastructure can yield unusually high returns because it increases people’s choices: of where to live and work, what to consume, what sort of economic activities to carry out, and of other people to communicate with. Some parts of a country’s infrastructure may be a natural monopoly, such as water pipes. Others, such as traffic lights, may be public goods. Some may have a network effect, such as telephone cables. Each of these factors has encouraged government provision of infra¬structure, often with the familiar downsides of state intervention: bad planning, inefficient delivery and corruption.
Industry:Economy
Rising prices, across the board. Inflation means less bang for your buck, as it erodes the purchasing power of a unit of currency. Inflation usually refers to consumer prices, but it can also be applied to other prices (wholesale goods, wages, assets, and so on). It is usually expressed as an annual percentage rate of change on an index number. For much of human history inflation has not been an important part of economic life. Before 1930, prices were as likely to fall as rise during any given year, and in the long run these ups and downs usually cancelled each other out. By contrast, by the end of the 20th century, 60-year-old Americans had seen prices rise by over 1,000% during their lifetime. The most spectacular period of inflation in industrialized countries took place during the 1970s, partly as a result of sharp increases in oil prices implemented by the OPEC cartel. Although these countries have mostly regained control over inflation since the 1980s, it continued to be a source of serious problems in many developing countries. Inflation would not do much damage if it were predictable, as everybody could build into their decision making the prospect of higher prices in future. In practice, it is unpredictable, which means that people are often surprised by price increases. This reduces economic efficiency, not least because people take fewer risks to minimize the chances of suffering too severely from a price shock. The faster the rate of inflation, the harder it is to predict future inflation. Indeed, this uncertainty can cause people to lose confidence in a currency as a store of value. This is why hyper-inflation is so damaging. Most economists agree that an economy is most likely to function efficiently if inflation is low. Ideally, macroeconomic policy should aim for stable prices. Some economists argue that a low level of inflation can be a good thing, however, if it is a result of innovation. New products are launched at high prices, which quickly come down through competition. Most economists reckon that deflation (falling average prices) is best avoided. To keep inflation low you need to know what causes it. Economists have plenty of theories but no absolutely cast-iron conclusions. Inflation, Milton Friedman once said, “is always and everywhere a monetary phenomenon”. Monetarists reckon that to stabilize prices the rate of growth of the money supply needs to be carefully controlled. However, implementing this has proven difficult, as the relationship between measures of the money supply identified by monetarists and the rate of inflation has typically broken down as soon as policymakers have tried to target it. Keynesian economists believe that inflation can occur independently of monetary conditions. Other economists focus on the importance of institutional factors, such as whether the interest rate is set by politicians or (preferably) by an independent central bank, and whether that central bank is set an inflation target. Is there a relationship between inflation and the level of unemployment? In the 1950s, the Phillips curve seemed to indicate that policymakers could trade off higher inflation for lower unemployment. Later experience suggested that although inflating the economy could lower unemployment in the short run, in the long run you ended up with unemployment at least as high as before and rising inflation as well. Economists then came up with the idea of the NAIRU (non-accelerating inflation rate of unemployment), the rate of unemployment below which inflation would start to accelerate. However, in the late 1990s, in both the United States and the UK, the unemployment rate fell well below what most economists thought was the NAIRU yet inflation did not pick up. This caused some economists to argue that technological and other changes wrought by the new economy meant that inflation was dead. Traditionalists said it was merely resting.
Industry:Economy
Does economic growth create more or less equality? Do unequal societies grow more or less slowly than equal ones? Economists have debated these questions for as long as anyone can remember. One problem is to agree which sort of inequality matters: equality of outcome (that is, income) or of opportunity? Another is how then to measure it. Equality of opportunity, which, in theory, should make a difference to growth, because it is about giving people the chance to make the most of their human capital, is probably beyond the ability of statisticians to analyze rigorously. The most often used measure of income inequality is the Gini coefficient. The evidence suggests that extreme poverty is more likely to slow growth than income inequality itself. This is because very poor people cannot buy the education they need to enable them to become richer and their children may be forced to forgo schooling in order to work for money. Economic growth has generally reduced inequality within a country. This has been partly as a result of redistributive tax and benefits systems, which have become so significant that they may now be causing slower growth in some countries. The availability of welfare benefits may have discouraged unemployed people from seeking out a better job; and the high taxes needed to pay for the benefits may have discouraged some wealthy people from working as hard as they would have done under a friendlier tax regime. However, the new economy may see inequality in rich countries widen again, thanks to its alleged winner-takes-all distribution of financial rewards.
Industry:Economy
Referee and, when the need arises, rescuer of the world’s financial system. The IMF was set up in 1944 at Bretton Woods, along with the World Bank, to supervise the newly established fixed exchange rate system. After this fell apart in 1971–73, the IMF became more involved with its member countries’ economic policies, doling out advice on fiscal policy and monetary policy as well as microeconomic changes such as privatization, of which it became a forceful advocate. In the 1980s, it played a leading part in sorting out the problems of developing countries’ mounting debt. More recently, it has several times co-ordinated and helped to finance assistance to countries with a currency crisis. The Fund has been criticized for the conditionality of its support, which is usually given only if the recipient country promises to implement IMF-approved economic reforms. Unfortunately, the IMF has often approved “one size fits all” policies that, not much later, turned out to be inappropriate. It has also been accused of creating moral hazard, in effect encouraging governments (and firms, banks and other investors) to behave recklessly by giving them reason to expect that if things go badly the IMF will organize a bail-out. Indeed, some financiers have described an investment in a financially shaky country as a “moral-hazard play” because they were so confident that the IMF would ensure the safety of their money, one way or another. Following the economic crisis in Asia during the late 1990s, and again after the crisis in Argentina early in this decade, some policymakers argued (to no avail) for the IMF to be abolished, as the absence of its safety net would encourage more prudent behavior all round. More sympathetic folk argued that the IMF should evolve into a global lender of last resort.
Industry:Economy
Founded in 1919 as part of the Treaty of Versailles, which created the League of Nations. In 1946, it became the first specialized agency of the UN. Based in Geneva, it formulates international labor standards, setting out desired minimum rights for workers: freedom of association; the right to organize and engage in collective bargaining; equality of opportunity and treatment; and the abolition of forced labor. It also compiles international labor statistics. One reason for its formation was the hope that international labor standards would stop countries using lower standards to gain a competitive advantage. From the 1980s onwards, the ILO approach came under attack as attention turned to the costs of high labor standards, notably slower economic growth. Universal minimum labor standards might also work against free trade. Imposing rich-country labor standards on poorer countries might help keep the rich rich and the poor poor.
Industry:Economy
A helping hand for poor countries from rich countries. This, at least, is the intention. In practice, in many cases aid has done little good for its intended recipients (improved health care is a notable exception) and has sometimes made matters worse. Poor countries that receive lots of aid grow no faster, on average, than those that receive very little. By contrast, perhaps the most successful aid program ever – the Marshall plan for rebuilding Europe after the second world war – involved rich countries giving to other hitherto rich countries. During the second half of the 20th century rich countries gave over $1 trillion in aid to poor ones. During the 1990s, however, flows of official aid stagnated. In 2001, official aid was a little over $50 billion, roughly one quarter of the GDP of donor countries. On top of this were private-sector donations from NGOs (non-government organizations) worth an estimated $6 billion. Increasingly, such sums were exceeded by private foreign direct investment. In an attempt to reinvigorate international aid, in 2000 the UN committed itself to eight ambitious Millennium Development Goals for reducing global poverty by 2015. Why has aid achieved so little? Donations have often ended up in the offshore bank accounts of corrupt politicians and officials in poor countries. Money has often been given with strings attached, so that much of this “tied” aid is spent on com¬panies and corrupt politicians and officials in the donor country. War has ravaged many potentially beneficial aid projects. Moreover, some aid has been motivated by political goals – for example, shoring up anti-communist governments – rather than economic ones. The lesson of history is that aid will often be wasted unless it is carefully aimed at countries with a genuine commitment to sound economic management. Analysis by the World Bank sorted 56 aid-receiving countries by the quality of their economic management. Those with good policies (low inflation, a budget surplus and openness to trade) and good institutions (little corruption, strong rule of law, effective bureaucracy) benefited from the aid they received. Those with poor policies and institutions did not. This accounts for the growing popularity of conditionality in aid.
Industry:Economy
Interest is usually expressed at an annual rate: the amount of interest that would be paid during a year divided by the amount of money loaned. Developed economies offer many different interest rates, reflecting the length of the loan and the riskiness and wealth of the borrower. People often use the term “interest rate” when they mean the short-term interest rate charged to banks. For instance, when a central bank raises or cuts interest rates, it changes only the price it charges to banks borrowing money overnight, expressed as an annual rate. Bond yields are a better measure of the interest rate on loans that do not have to be repaid for many years. Unlike short-term interest rates, bond yields are determined not by central bankers but by the supply and demand for money, which is heavily influenced by the expected rate of inflation.
Industry:Economy
