Backwardation
When a commodity is valued more highly in a spot market
(that is, when it is for delivery today) than in a futures market (for delivery
at some point in the future). Normally, interest costs mean that futures prices
are higher than spot prices, unless the markets expect the price of the
commodity to fall over time, perhaps because there is a temporary bottleneck in
supply. When spot prices are lower than futures prices it is known as contango.
Balance of payments
The total of all the money coming into a country from abroad
less all of the money going out of the country during the same period. This is
usually broken down into the current account and the capital account. The
current account includes:
- visible trade (known as merchandise trade in the United States), which is the value of exports and imports of physical goods;
- invisible trade, which is receipts and payments for services, such as banking or advertising, and other intangible goods, such as copyrights, as well as cross-border dividend and interest payments;
- private transfers, such as money sent home by expatriate workers;
- official transfers, such as international aid.
The capital account includes:
- long-term capital flows, such as money invested in foreign firms, and profits made by selling those investments and bringing the money home;
- short-term capital flows, such as money invested in foreign currencies by international speculators, and funds moved around the world for business purposes by multinational companies. These short-term flows can lead to sharp movements in exchange rates, which bear little relation to what currencies should be worth judging by fundamental measures of value such as purchasing power parity.
As bills must be paid, ultimately a country's accounts must
balance (although because real life is never that neat a balancing item is
usually inserted to cover up the inconsistencies).
"Balance of payments crisis" is a politically
charged phrase. But a country can often sustain a current account deficit for
many years without its economy suffering, because any deficit is likely to be
tiny compared with the country's national income and wealth. Indeed, if the
deficit is due to firms importing technology and other capital goods from
abroad, which will improve their productivity, the economy may benefit. A
deficit that has to be financed by the public sector may be more problematic,
particularly if the public sector faces limits on how much it can raise taxes
or borrow or has few financial reserves. For instance, when the Russian government
failed to pay the interest on its foreign debt in August 1998 it found it
impossible to borrow any more money in the international financial markets. Nor
was it able to increase taxes in its collapsing economy or to find anybody
within Russia willing to lend it money. That truly was a balance of payments
crisis.
In the early years of the 21st century, economists started
to worry that the United States would find itself in a balance of payments
crisis. Its current account deficit grew to over 5% of its GDP, making its
economy increasingly reliant on foreign credit.
Balanced budget
When total public-sector spending equals total government
income during the same period from taxes and charges for public services.
Politicians in some countries, such as the United States, have argued that
government should be required to run a balanced budget in order to have sound
public finances. However, there is no economic reason why public borrowing need
necessarily be bad. For instance, if the debt is used to invest in things that
will increase the growth rate of the economy--infrastructure, say, or
education--it may be justified. It may also make more economic sense to try to
balance the budget on average over an entire economic cycle, with public-sector
deficits boosting the economy during recession and surpluses stopping it
overheating during booms, than to balance it every year.
Bank
Starting out as places that would guard your money, banks
became the main source of credit creation. Increasingly, however, borrowers are
turning to the financial markets and to non-savings institutions, such as
credit-card companies and consumer-finance firms, when they need a loan. This
is reducing the profitability of traditional bank lending and has led many
banks to enter new areas of business, such as selling insurance policies and
mutual funds. Increasingly, too, traditional banks are selling off parcels of
their loans in the financial markets by a process called securitisation.
What the most efficient split is between bank lending and
other sorts of lending is debatable. Economists argue endlessly about whether
an economy such as the United States, in which firms rely more heavily on the
equity and debt markets than on banks to fund their investment, is better than
one such as, say, Germany, in which banks have traditionally been the main
source of corporate finance.
Banks come in many different forms. Commercial banks, also
known as retail banks, cater directly for the general public and lend to
(mostly small and medium-sized) firms. In the past, they did so largely through
a network of bank branches, although increasingly these are giving way to atm
machines, the telephone and the Internet. Wholesale banks largely transact with
other banks and financial institutions. Investment banks, also known as
merchant banks, concentrate on raising money for companies from private
investors or in the financial markets, by finding buyers for their equity and
corporate bonds. Universal banks do most or all of the above including, through
bancassurance, selling insurance. These banks have long been a feature of
continental European economies. However, in the United States financial laws
such as the Glass-Steagall Act have separated different forms of banking from
each other and kept banks out of the insurance business. These laws were
abolished in 1999, although during the preceding couple of decades regulators
effectively dismantled them by changing the way they were applied. Even so,
because of these and other laws, which for many years stopped banks from
operating across state borders, the United States has far more lending
institutions than other countries. In 2003 there were over four lending
institutions per 100,000 people in the United States, compared with fewer than
one per 100,000 in the UK and France.
Bankruptcy
When a court judges that a debtor is unable to make the
payments owed to a creditor. How bankrupts are treated can affect economic
growth. If bankrupts are punished too severely, would-be entrepreneurs may be
discouraged from taking the financial risks needed to make the most of their
ideas. However, letting off defaulting debtors too readily may discourage
potential creditors because of moral hazard.
America's bankruptcy code, in particular its Chapter 11
protection for firms from their creditors, is particularly friendly to troubled
borrowers, allowing them to borrow more money and giving them time to work out
their problems. Some other countries quickly close down a bankrupt firm, and
try to repay its debts by selling off any assets it has.
Barriers to entry (or
exit)
How firms keep out competition--an important source of
incumbent advantage. There are four main sorts of barriers.
- A firm may own a crucial resource, such as an oil well, or it may have an exclusive operating licence, for instance, to broadcast on a particular radio wavelength.
- A big firm with economies of scale may have a significant competitive advantage because it can produce a large output at lower costs than can a smaller potential rival.
- An incumbent firm may make it hard for a would-be entrant by incurring huge sunk costs, spending lots of money on things such as advertising, which any rival must match to compete effectively but which have no value if the attempt to compete should fail.
- Powerful firms can discourage entry by raising exit costs, for example, by making it an industry norm to hire workers on long-term contracts, which make firing an expensive process.
Barter
Paying for goods or services with other goods or services,
instead of with money. It is often popular when the quality of money is low or
uncertain, perhaps because of high inflation or counterfeiting, or when people
are asset-rich but cash-poor, or when taxation or extortion by criminals is
high. Little wonder, then, that barter became popular in Russia during the late
1990s.
Basel 1 and 2
An attempt to reduce the number of bank failures by tying a
bank's capital adequacy ratio to the riskiness of the loans it makes. For
instance, there is less chance of a loan to a government going bad than a loan
to, say, an internet business, so the bank should not have to hold as much
capital in reserve against the first loan as against the second. The first
attempt to do this worldwide was by the Basel committee for international
banking supervision in 1988. However, its system of judging the relative
riskiness of different loans was crude. For instance, it penalised banks no
more for making loans to a fly-by-night software company in Thailand than to
Microsoft; no more for loans to South Korea, bailed out by the IMF in 1998,
than to Switzerland. In 1998, "Basel 2" was proposed, using much more
sophisticated risk classifications. However, controversy over these new classifications,
and the cost to banks of administering the new approach, led to the
introduction of Basel 2 being delayed until (at least) 2005.
Basis point
One one-hundredth of a percentage point. Small movements in
the interest rate, the exchange rate and bond yields are often described in
terms of basis points. If a bond yield moves from 5.25% to 5.45%, it has risen
by 20 basis points.
Bear
An investor who thinks that the price of a particular
security or class of securities (shares, say) is going to fall; the opposite of
a bull.
Behavioural economics
A branch of economics that concentrates on explaining the
economic decisions people make in practice, especially when these conflict with
what conventional economic theory predicts they will do. Behaviourists try to
augment or replace traditional ideas of economic rationality (homo economicus)
with decision-making models borrowed from psychology. According to
psychologists, people are disproportionately influenced by a fear of feeling
regret and will often forgo benefits even to avoid only a small risk of feeling
they have failed. They are also prone to cognitive dissonance, often holding on
to a belief plainly at odds with new evidence, usually because the belief has
been held and cherished for a long time. Then there is anchoring: people are
often overly influenced by outside suggestion. People apparently also suffer
from status quo bias: they are willing to take bigger gambles to maintain the
status quo than they would be to acquire it in the first place.
Traditional utility theory assumes that people make
individual decisions in the context of the big picture. But psychologists have
found that they generally compartmentalise, often on superficial grounds. They
then make choices about things in one particular mental compartment without
taking account of the implications for things in other compartments.
There is lots of evidence that people are persistently and
irrationally overconfident. They are also vulnerable to hindsight bias: once
something happens they overestimate the extent to which they could have
predicted it. Many of these traits are captured in prospect theory, which is at
the heart of much of behavioural economics.
Part of an economic theory for valuing financial securities
and calculating the cost of capital, known as the capital asset pricing model,
beta measures the sensitivity of the price of a particular asset to changes in
the market as a whole. If a company's shares have a beta of 0.8 it implies that
on average the share price will change by 0.8% if there is a 1% change in the
market. There is a long-running debate about whether a beta calculated from a
security's past relationship with the market actually predicts how that
relationship will behave in future, leading some doubting economists to claim
that beta is "dead".
Big Mac index
The Big Mac index was devised by Pam Woodall of The
Economist in 1986, as a light-hearted guide to whether currencies are at their
"correct" level. It is based on one of the oldest concepts in
international economics, purchasing power parity (PPP), the notion that a
dollar, say, should buy the same amount in all countries. In the long run,
argue ppp fans, currencies should move towards the exchange rate, which
equalises the prices of an identical basket of goods and services in each
country. In this case, the basket is a McDonalds' Big Mac, which is produced in
more than 100 countries. The Big Mac PPP is the exchange rate that would leave
hamburgers costing the same in the United States as elsewhere. Comparing actual
exchange rates with PPP signals whether a currency is undervalued or
overvalued. Some studies have found that the Big Mac index is often a better
predictor of currency movements than more theoretically rigorous models.
Black economy
If you pay your cleaner or builder in cash, or for some
reason neglect to tell the taxman that you were paid for a service rendered,
you participate in the black or underground economy. Such transactions do not
normally show up in the figures for GDP, so the black economy may mean that a
country is much richer than the official data suggest. In the United States and
the UK, the black economy adds an estimated 5-10% to GDP; in Italy, it may add
30%. As for Russia, in the late 1990s estimates of the black economy ranged as
high as 50% of GDP.
Black-Scholes
A formula for pricing financial options. Its invention
allowed a previously undreamed of precision in the pricing of options (which
had hitherto been done using crude rules of thumb), and probably made possible
the explosive growth in the markets for options and other derivatives that took
place after the formula became widely used in the early 1970s. Myron Scholes
and Robert Merton were awarded the nobel prize for economics for their part in
devising the formula; their co-inventor, Fischer Black (1938-95), was
ineligible, having died.
Bonds
Gentlemen prefer bonds, punned Andrew Mellon, an American
tycoon. A bond is an interest-bearing security issued by governments, companies
and some other organisations. Bonds are an alternative way for the issuer to
raise capital to selling shares or taking out a bank loan. Like shares in
listed companies, once they have been issued bonds may be traded on the open
market. A bond's yield is the interest rate (or coupon) paid on the bond divided
by the bond's market price. Bonds are regarded as a lower risk investment.
government bonds, in particular, are highly unlikely to miss their promised
payments. Corporate bonds issued by blue-chip "investment grade"
companies are also unlikely to default; this might not be the case with
high-yield "junk" bonds issued by firms with less healthy financials.
Bounded rationality
A theory of human decision making that assumes that people
behave rationally, but only within the limits of the information available to
them. Because their information may be inadequate (bounded) they make take
decisions that appear to be irrational according to traditional theories about
homo economicus (economic man).
Brand
The stalking-horse for international capitalism. A focus for
all the worries about environmental damage, human-rights abuses and sweated
labour that opponents of globalisation like to put on their placards. A symbol
of America's corporate power, since most of the world's best-known brands, from
Coca Cola to Nike, are American. That is the case against.
Many economists regard brands as a good thing, however. A
brand provides a guarantee of reliability and quality. Consumer trust is the
basis of all brand values. So companies that own the brands have an immense
incentive to work to retain that trust. Brands have value only where consumers
have choice. The arrival of foreign brands, and the emergence of domestic
brands, in former communist and other poorer countries points to an increase in
competition from which consumers gain. Because a strong brand often requires
expensive advertising and good marketing, it can raise both price and barriers
to entry. But not to insurperable levels: brands fade as tastes change; if
quality is not maintained, neither is the brand.
Bretton Woods
A conference held at Bretton Woods, New Hampshire, in 1944,
which designed the structure of the international monetary system after the
second world war and set up the imf and the world bank. It was agreed that the
exchange rates of IMF members would be pegged to the dollar, with a maximum
variation of 1% either side of the agreed rate. Rates could be adjusted more
sharply only if a country's balance of payments was in fundamental
disequilibrium. In August 1971 economic troubles and the cost of financing the
Vietnam war led the American president, Richard Nixon, to devalue the dollar.
This shattered confidence in the fixed exchange rate system and by 1973 all of
the main currencies were floating freely, at rates set mostly by market forces
rather than government fiat.
Bubble
When the price of an asset rises far higher than can be
explained by fundamentals, such as the income likely to derive from holding the
asset. The Chicago Tribune of April 13th 1890, writing about the then mania in
real-estate prices, described "men who bought property at prices they knew
perfectly well were fictitious, but who were prepared to pay such prices simply
because they knew that some still greater fool could be depended on to take the
property off their hands and leave them with a profit". Such behaviour is
a feature of all bubbles.
Famous bubbles include tulip mania in Holland during the
17th century, when the prices of tulip bulbs reached unheard of levels, and the
South Sea Bubble in Britain a century later, although there have been many
others since, including the dotcom bubble in internet company shares that burst
in 2000. Economists argue about whether bubbles are the result of irrational
crowd behaviour (perhaps coupled with exploitation of the gullible masses by
some savvy speculators) or, instead, are the result of rational decisions by
people who have only limited information about the fundamental value of an
asset and thus for whom it may be quite sensible to assume the market price is
sound. Whatever their cause, bubbles do not last forever and often end not with
a pop but with a crash.
Budget
An annual procedure to decide how much public spending there
should be in the year ahead and what mix of taxation, charging for services and
borrowing should finance it. The budgeting process differs enormously from one
country to another. In the United States, for example, the president proposes a
budget in February for the fiscal year starting the following October, but this
has to be approved by Congress. By the time a final decision has to be made,
ideally, no later than September, there are often three competing versions: the
president's latest proposal, one from the Senate and another from the House of
Representatives. What finally emerges is the result of last-minute negotiations.
Occasionally, delays in agreeing the budget have led to the temporary closure
of some federal government offices. Contrast this with the UK, where most of
what the government proposes is usually approved by parliament, and some
changes take effect as soon as they are announced (subject to subsequent
parliamentary vote).
Bull
An investor who expects the price of a particular security
to rise; the opposite of a bear.
Business confidence
How the people who run companies feel about their
organisations' prospects. In many countries, surveys measure average business
confidence. These can provide useful signs about the current condition of the
economy, because companies often have information about consumer demand sooner
than government statisticians do.
Business cycle
The long-run pattern of economic growth and recession.
According to the Centre for International Business Cycle Research at Columbia
University, between 1854 and 1945 the average expansion lasted 29 months and
the average contraction 21 months. Since the second world war, however,
expansions have lasted almost twice as long, an average of 50 months, and
contractions have shortened to an average of only 11 months. Over the years,
economists have produced numerous theories of why economic activity fluctuates
so much, none of them particularly convincing. A Kitchin cycle supposedly
lasted 39 months and was due to fluctuations in companies' inventories. The
Juglar cycle would last 8-9 years as a result of changes in investment in plant
and machinery. Then there was the 20-year Kuznets cycle, allegedly driven by
house-building, and, perhaps the best-known theory of them all, the 50-year
kondratieff wave. hayek tangled with keynes over what caused the business
cycle, and won the nobel prize for economics for his theory that variations in
an economy's output depended on the sort of capital it had. Taking a quite
different tack, in the late 1960s Arthur Okun, an economic adviser to
presidents Kennedy and Johnson, proclaimed that the business cycle was
"obsolete". A year later, the American economy was in recession.
Again, in the late 1990s, some economists claimed that technological innovation
and globalisation meant that the business cycle was a thing of the past. Alas,
they were soon proved wrong.
Buyer's market
A market in which supply seems plentiful and prices seem
low; the opposite of a seller's market.
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