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The Economist Newspaper Ltd
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Number of terms: 15233
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A sudden fall in the value of a currency against other currencies. Strictly, devaluation refers only to sharp falls in a currency within a fixed exchange rate system. Also it usually refers to a deliberate act of government policy, although in recent years reluctant devaluers have blamed financial speculation. Most studies of devaluation suggest that its beneficial effects on competitiveness are only temporary; over time they are eroded by higher prices (see j-curve).
Industry:Economy
Financial assets that “derive” their value from other assets. For example, an option to buy a share is derived from the share. Some politicians and others responsible for financial regulation blame the growing use of derivatives for increasing volatility in asset prices, and for being a source of danger to their users. Economists mostly regard derivatives as a good thing, allowing more precise pricing of financial risk and better risk management. However, they concede that when derivatives are misused the leverage that is often an integral part of them can have devastating consequences. So they come with an economists’ health warning: if you don’t understand it, don’t use it. The world of derivatives is riddled with jargon. Here are translations of the most important bits. * A forward contract commits the user to buying or selling an asset at a specific price on a specific date in the future. * A future is a forward contract that is traded on an exchange. * A swap is a contract by which two parties exchange the cashflow linked to a liability or an asset. For example, two companies, one with a loan on a fixed interest rate over ten years and the other with a similar loan on a floating interest rate over the same period, may agree to take over each other’s obligations, so that the first pays the floating rate and the second the fixed rate. * An option is a contract that gives the buyer the right, but not the obligation, to sell or buy a particular asset at a particular price, on or before a specified date. * An over-the-counter is a derivative that is not traded on an exchange but is purchased from, say, an investment bank. * Exotics are derivatives that are complex or are available in emerging economies. * Plain-vanilla derivatives, in contrast to exotics, are typically exchange-traded, relate to developed economies and are comparatively uncomplicated.
Industry:Economy
Cutting red tape. The process of removing legal or quasi-legal restrictions on the amount of competition, the sorts of business done, or the prices charged within a particular industry. During the last two decades of the 20th century, many governments committed to the free market pursued policies of liberalization based on substantial amounts of deregulation hand-in-hand with the privatization of industries owned by the state. The aim was to decrease the role of government in the economy and to increase competition. Even so, red tape is alive and well. In the United States, with some 60 federal agencies issuing more than 1,800 rules a year, in 1998 the Code of Federal Regulations was more than 130,000 pages thick. However, not all regulation is necessarily bad. According to estimates by the American Office of Management and Budget, the annual cost of these rules was $289 billion, but the annual benefits were $298 billion.
Industry:Economy
A bad, depressingly prolonged recession in economic activity. The textbook definition of a recession is two consecutive quarters of declining output. A slump is where output falls by at least 10%; a depression is an even deeper and more prolonged slump. The most famous example is the Great Depression of the 1930s. After growing strongly during the “roaring 20s”, the American economy (among others) went into prolonged recession. Output fell by 30%. Unemployment soared and stayed high: in 1939 the jobless rate was still 17% of the workforce. Roughly half of the 25,000 banks in the United States failed. An attempt to stimulate growth, the New Deal, was the most far-reaching example of active fiscal policy then seen and greatly extended the role of the state in the American economy. However, the depression only ended with the onset of preparations to enter the second world war. Why did the Great Depression happen? It is not entirely clear, but forget the popular explanation: that it all went wrong with the Wall Street stock market crash of October 1929; that the slump persisted because policymakers just sat there; and that it took the New Deal to put things right. As early as 1928 the Federal Reserve, worried about financial speculation and inflated stock prices, began raising interest rates. In the spring of 1929, industrial production started to slow; the recession started in the summer, well before the stock market lost half of its value between October 24th and mid-November. Coming on top of a recession that had already begun, the crash set the scene for a severe contraction but not for the decade-long slump that ensued. So why did a bad downturn keep getting worse, year after year, not just in the United States but also around the globe? In 1929 most of the world was on the gold standard, which should have helped stabilize the American economy. As demand in the United States slowed its imports fell, its balance of payments moved further into surplus and gold should have flowed into the country, expanding the money supply and boosting the economy. But the Fed, which was still worried about easy credit and speculation, dampened the impact of this adjustment mechanism, and instead the money supply got tighter. Governments everywhere, hit by falling demand, tried to reduce imports through tariffs, causing international trade to collapse. Then American banks started to fail, and the Fed let them. As the crisis of confidence spread more banks failed, and as people rushed to turn bank deposits into cash the money supply collapsed. Bad monetary policy was abetted by bad fiscal policy. Taxes were raised in 1932 to help balance the budget and restore confidence. The New Deal brought deposit insurance and boosted government spending, but it also piled taxes on business and sought to prevent excessive competition. Price controls were brought in, along with other anti-business regulations. None of this stopped – and indeed may well have contributed to – the economy falling into recession again in 1937–38, after a brief recovery starting in 1935.
Industry:Economy
A fall in the value of an asset or a currency; the opposite of appreciation.
Industry:Economy
Protection for your savings, in case your bank goes Bust. Arrangements vary around the world, but in most countries deposit insurance is required by the government and paid for by banks (and, ultimately, their customers), which contribute a small slice of their assets to a central, usually government-run, insurance fund. If a bank defaults, this fund guarantees its customers’ deposits, at least up to a certain amount. By reassuring banks’ customers that their cash is protected, deposit insurance aims to prevent them from panicking and causing a bank run, and thereby reduces systemic risk. The United States introduced it in 1933, after a massive bank panic led to widespread bankruptcy, deepening its depression. The downside of deposit insurance is that it creates a moral hazard. By insulating depositors from defaults, deposit insurance reduces their incentive to monitor banks closely. Also banks can take greater risks, safe in the knowledge that there is a state-financed safety net to catch them if they fall. There are no easy solutions to this moral hazard. One approach is to monitor what banks do very closely. This is easier said than done, not least because of the high cost. Another is to ensure capital adequacy by requiring banks to set aside, just in case, specified amounts of capital when they take on different amounts of risk. Alternatively, the state safety net could be shrunk, by splitting banks into two types: super-safe, government-insured “narrow banks” that stick to traditional business and invest only in secure assets; and uninsured institutions, “broad banks”, that could range more widely under a much lighter regulatory system. Savers who invested in a broad bank would probably earn much higher returns because it could invest in riskier assets; but they would also lose their shirts if it went bust. Yet another possible answer is to require every bank to finance a small proportion of its assets by selling subordinated debt to other institutions, with the stipulation that the yield on this debt must not be more than so many (say 50) basis points higher than the rate on a corresponding risk-free instrument. Subordinated debt (uninsured certificates of deposit) is simply junior debt. Its holders are at the back of the queue for their money if the bank gets into trouble and they have no safety net. Investors will buy subordinated debt at a yield quite close to the risk-free interest rate only if they are sure the bank is low risk. To sell its debt, the bank will have to persuade informed investors of this. If it cannot convince them it cannot operate. This exploits the fact that bankers know more about banking than do their supervisors. It asks banks not to be good citizens but to look only to their profits. Unlike the present regime, it exploits all the available information and properly aligns everybody’s incentives. This ingenious idea was first tried in Argentina, where it became a victim of the country's economic, banking and political crisis of 2001-02 before it really had a chance to prove itself.
Industry:Economy
People, and the statistical study of them. In the 200 years since Thomas Malthus forecast that population growth would result in mass starvation, dire predictions based on demographic trends have come to be taken with a pinch of salt. Even so, demography does matter. In developed countries, economists have studied the impact of the post-war “baby-boomer” population bulge as it has grown older. In the 1980s, as the bulge dominated the workforce, it may have contributed to a sharp, if temporary, rise in unemployment in many countries. Boomers starting to save for retirement may have increased demand for shares, so fuelling the bull stock market of the 1990s; as they retire and sell their shares for spending money, they may cause a long bear market. Furthermore, as they become elderly and retire, health-care spending and retirement pensions are likely to eat up a growing share of GDP. To the extent that these are provided by the state, this will mean increasing public spending and higher taxes. But whether they are provided by the state or by the private sector, the ageing of baby-boomers will impose a growing financial burden on the younger workers that have to support them (see replacement rate). Economists have tried to measure the extent of this burden using generational accounting, which looks at the amount of wealth transferred from one generation to another over the lifetimes of the members of each generation. Economists have also developed many different theories to explain why populations grow and why the fertility rate slowed sharply, to below the replacement rate, in many developed countries during the 1990s. One explanation is based on the notion that people have children so that there is somebody to look after them in old age. Fertility rates fell because the state increasingly looked after retired people, and infant mortality rates were lower so fewer births were required to ensure that there were some children around in the parental dotage. Also, with a lower probability of a child dying, it paid the parents to have fewer children and to channel their energy and resources into maximizing the human capital of the few. Alternatively, it may have had something to do with an important innovation: the cheap and easy availability of reliable contraception.
Industry:Economy
A graph showing the relationship between the price of a good and the amount of demand for it at different prices. (See also supply curve. )
Industry:Economy
One of the two words economists use most; the other is supply. These are the twin driving forces of the market economy. Demand is not just about measuring what people want; for economists, it refers to the amount of a good or service that people are both willing and able to buy. The demand curve measures the relationship between the price of a good and the amount of it demanded. Usually, as the price rises, fewer people are willing and able to buy it; in other words, demand falls (but see Giffen goods, normal goods and inferior goods). When demand changes, economists explain this in one of two ways. A movement along the demand curve occurs when a price change alters the quantity demanded; but if the price were to go back to where it was before, so would the amount demanded. A shift in the demand curve occurs when the amount demanded would be different from what it was previously at any chosen price, for example, if there is no change in the market price, but demand rises or falls. The slope of the demand curve indicates the elasticity of demand. For approaches to modeling demand see revealed preference. Policymakers seek to manipulate aggregate demand to keep the economy growing as fast as is possible without pushing up inflation. Keynesians try to manage demand through fiscal policy; monetarists prefer to use the money supply. Neither approach has been especially successful in practice, particularly when attempting to manage short-term demand through fine tuning.
Industry:Economy
Since 1930 it has been the norm in most developed countries for average prices to rise year after year. However, before 1930 deflation (falling prices) was as likely as inflation. On the eve of the First World War, for example, prices in the UK, overall, were almost exactly the same as they had been at the time of the great fire of London in 1666. Deflation is a persistent fall in the general price level of goods and services. It is not to be confused with a decline in prices in one economic sector or with a fall in the inflation rate (which is known as disinflation). Sometimes deflation can be harmless, perhaps even a good thing, if lower prices lift real income and hence spending power. In the last 30 years of the 19th century, for example, consumer prices fell by almost half in the United States, as the expansion of railways and advances in industrial technology brought cheaper ways to make everything. Yet annual real GDP growth over the period averaged more than 4%. Deflation is dangerous, however, more so even than inflation, when it reflects a sharp slump in demand, excess capacity and a shrinking money supply, as in the Great depression of the early 1930s. In the four years to 1933, American consumer prices fell by 25% and real GDP by 30%. Runaway deflation of this sort can be much more damaging than runaway inflation, because it creates a vicious spiral that is hard to escape. The expectation that prices will be lower tomorrow may encourage consumers to delay purchases, depressing demand and forcing firms to cut prices by even more. Falling prices also inflate the real burden of debt (that is, increase real interest rates) causing bankruptcy and bank failure. This makes deflation particularly dangerous for economies that have large amounts of corporate debt. Most serious of all, deflation can make monetary policy ineffective: nominal interest rates cannot be negative, so real rates can get stuck too high.
Industry:Economy