Tuesday, August 10, 2010
What is the economy?
I bet if you asked most people what the economy was they wouldn’t be able to really define it. They’d say it’s “business” or the work we do or making money. It’s certainly all those things, but it’s really more.
Very simply, the economy can be defined as the sum total of everything that we produce here in America. That’s what we call GDP or, “Gross Domestic Product.”
There are four components to GDP. They are:
1. Personal consumption (C): That’s everything that individuals spend money on. It’s also the biggest component, comprising about 70% of GDP or, $10.3 trillion.
2. Business investment (I): That’s everything that businesses spend money on. That comprises about 13% of GDP or, about $1.8 trillion.
3. Net Exports (NE): That’s the sum of exports minus imports. This number is pretty much always negative because we pretty much always run a trade deficit (imports being larger than exports). At the current time net exports subtract about $520 billion from GDP or -4%.
4. Government (G): This is everything the government spends money on. That comprises about 21% of GDP or, $3 trillion.
(Add them all together and they all add up to 100%)
Now that you know the four components or “ingredients,” you should understand that the economy can be expressed as a simple arithmetic equation that looks like this
GDP = C + I + G –NE
Where C equals consumption, I equals business investment, G equals government, and NE equals net exports (which is almost always negative as I said).
Once you see how simple this is, you can see how you can manipulate the equation to come up with any desired outcome.
Here’s an example.
Suppose C=3, I=2, G=1, NE=-1
Plugging those variables into the equation we get:
GDP = 3 +2 + 1 -1
Therefore, GDP = 5.
Changing any one of the variables or all of the variables changes the outcome.
So if government spending goes up, rather than get all excited and worried about it, just plug the new number into the equation and see what happens.
If government spending (G) goes from +1 to +2 and the rest of the equation stays the same, we get:
GDP = 3 + 2 +2 -1
Therefore, GDP = 6.
In other words, GDP has grown, it’s gotten bigger. That’s good for stocks!
Why is this important?
Because in the present environment government spending is the easiest variable to change. The others are lot tougher. (How do you expect people to consume more when they don’t have jobs, for example?) On the other hand the government really has no constraint to how much it can spend because it spends in its own money (the U.S. dollar and the gov’t is the monopoly issuer of its own currency) and spending is done by merely electronically crediting bank accounts.
Is there a risk to doing this? Yes. The risk is that spending without constraint will use up all the available capital (both physical and human capital) of the nation. Think of it like pushing your car past the “red line” on the tachometer. However, we are nowhere near that at the present time. We have millions of people (human capital) out of work and industry operating at only 70% of its capacity. In other words, we have a lot of capital not being used.
Hopefully, when you explain this to your friends and colleagues it will take some of the fear or misunderstanding out of the whole thing and it will help them see that there are opportunities when others may look at this as risk. It should also show that the way out of our mess is quite easy.