Basic Economics for Washington and You

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Most of us like to scoff at our representatives in Washington now and then. But we do generally assume that they know what they're doing.

Given our current economic crisis, though, it might disturb you to learn that, according to a Wall Street Journal piece, "[M]ore than 8 in 10 members of Congress don't have a formal educational background in the business, economics, or finance fields." Well, I guess that makes some sense. After all, all kinds of people run for public office -- they needn't be economists.

James Bowers of the Center for Economic and Entrepreneurial Literacy waxed harsh, saying, "It’s interesting that those who are responsible for solving the biggest economic crisis in generations don't have the educational background to know the difference between commercial paper and copy machine paper." I love a clever insult, but I also know that you needn't have majored in something in order to have a good grasp of it.

Still, it's kind of critical for politicians -- and us -- to understand basic economic concepts.

Terms explained
Let's review a few key terms, shall we?

• Opportunity cost: This represents what you give up doing in order to do something else -- it's the next-best thing you could do. Imagine that you have $5,000 and you're torn between investing it in Home Depot (NYSE: HD) or Best Buy (NYSE: BBY). You buy shares of Home Depot. That Best Buy purchase you gave up is your opportunity cost; if shares skyrocket, you missed out. Similarly, before Congress decides to spend $700 billion on a bailout, it should spend a little time thinking about what else it could have done, what its opportunity cost is. We spent $85 billion on a loan to bail out AIG (NYSE: AIG). That's more than the current market cap of Oracle (Nasdaq: ORCL) or Abbott Labs (NYSE: ABT). Was that our best use of that money?
• Supply and demand: It's supply and demand that create stock prices. If lots of people want a stock, since there is a finite supply, the price tends to rise. If banks today raise money by issuing many more shares, they will increase the supply, and prices will fall ("diluting" the stock) unless demand rises.
• Liquidity: This reflects how easily assets are turned into cash and how readily an entity can get money when it needs it. With today's credit crunch on Wall Street, easy money isn't being found anymore. Lenders have less money to lend and are being more selective in their lending.
• Human capital: Some companies are "capital-intensive," holding much of their value in land, factories, raw materials, and inventory. Others have lighter models, with much of a firm's value tied to the brains (the knowledge and skills) of employees. Microsoft (Nasdaq: MSFT) and Adobe (Nasdaq: ADBE) are examples of this. We have to hope that Congress is rich in human capital.
• Inflation: Sure, it's the rate at which price levels rise. But it has deep implications. For example, we shouldn't think of our investment returns without factoring in inflation. If we expect to earn an average of 10% over a period, for example, and inflation is 3%, then the "real" return is just 7%. If we're earning 2% in a bank account and inflation is 3%, then our real return is actually negative. Inflation was on the low side for many years, but it has been rising quickly lately -- look at gas and food prices, for example. If we plan to save $1 million by the time we retire in 30 years, we should realize that an average inflation rate of 4% during that period will reduce its purchasing power to more like $300,000 in today's dollars. For us to maintain the buying power of a million, we'd need to accumulate over $3.2 million by 2038. And as our government prints more money to address today's problems, concerns arise that it could create new inflation threats.
• Deficit: This is the net result of spending more money than we receive. We're well aware of government budget deficits, but many people also end up with personal deficits by racking up too much debt.
• Money: This isn't just paper currency printed by governments. It can be anything, as long as it holds some value and facilitates exchanges. In prisons these days, for example, cans of mackerel have become a form of money. As our dollar has been troubled lately, many people have flocked to gold, sending its value up.

Learn more
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