Cannibalise
Eating people is wrong. Eating your own business may not be. FIRMS used to be reluctant to launch new products and SERVICES that competed with what they were already doing, as the new thing would eat into (cannibalise) their existing business. In today's innovative, technology-intensive economy, however, a willingness to cannibalise is more often seen as a good thing. This is because INNOVATION often takes the form of what economists call creative destruction (see SCHUMPETER), in which a superior new product destroys the market for existing products. In this environment, the best course of action for successful firms that want to avoid losing their market to a rival with an innovation may be to carry out the creative destruction themselves.
Capacity
The amount a company or an economy can produce using its current equipment, workers, CAPITAL and other resources at full tilt. Judging how close an economy is to operating at full capacity is an important ingredient of MONETARY POLICY, for if there is not enough spare capacity to absorb an increase in DEMAND, PRICES are likely to rise instead. Measuring an economy's OUTPUT GAP - how far current OUTPUT is above or below what it would be at full capacity - is difficult, if not impossible, which is why even the best-intentioned CENTRAL BANK can struggle to keep down INFLATION. When there is too much spare capacity, however, the result can be DEFLATION, as FIRMS and employees cut their prices and wage demands to compete for whatever demand there may be.
Capital
MONEY or assets put to economic use, the life-blood of CAPITALISM. Economists describe capital as one of the four essential ingredients of economic activity, the FACTORS OF PRODUCTION, along with LAND, LABOUR and ENTERPRISE. Production processes that use a lot of capital relative to labour are CAPITAL INTENSIVE; those that use comparatively little capital are LABOUR INTENSIVE. Capital takes different forms. A firm's ASSETS are known as its capital, which may include fixed capital (machinery, buildings, and so on) and working capital (stocks of raw materials and part-finished products, as well as money, that are used up quickly in the production process). Financial capital includes money, BONDS and SHARES. HUMAN CAPITAL is the economic wealth or potential contained in a person, some of it endowed at birth, the rest the product of training and education, if only in the university of life. The invisible glue of relationships and institutions that holds an economy together is its social capital.
Capital adequacy ratio
The ratio of a BANK’s CAPITAL to its total ASSETS, required by regulators to be above a minimum (“adequate”) level so that there is little RISK of the bank going bust. How high this minimum level is may vary according to how risky a bank’s activities are.
Capital asset pricing model
A method of valuing ASSETS and calculating the COST OF CAPITAL (for an alternative, see ARBITRAGE PRICING THEORY). The capital asset pricing model (CAPM) has come to dominate modern finance.
The rationale of the CAPM can be simplified as follows. Investors can eliminate some sorts of RISK, known as RESIDUAL RISK or alpha, by holding a diversified portfolio of assets (see MODERN PORTFOLIO THEORY). These alpha risks are specific to an individual asset, for example, the risk that a company's managers will turn out to be no good. Some risks, such as that of a global RECESSION, cannot be eliminated through diversification. So even a basket of all of the SHARES in a stockmarket will still be risky. People must be rewarded for investing in such a risky basket by earning returns on AVERAGE above those that they can get on safer assets, such as TREASURY BILLS. Assuming investors diversify away alpha risks, how an investor values any particular asset should depend crucially on how much the asset's PRICE is affected by the risk of the market as a whole. The market's risk contribution is captured by a measure of relative volatility, BETA, which indicates how much an asset's price is expected to change when the overall market changes.
Safe investments have a beta close to zero: economists call these assets risk free. Riskier investments, such as a share, should earn a premium over the risk-free rate. How much is calculated by the average premium for all assets of that type, multiplied by the particular asset's beta.
But does the CAPM work? It all comes down to beta, which some economists have found of dubious use. They think the CAPM may be an elegant theory that is no good in practice. Yet it is probably the best and certainly the most widely used method for calculating the cost of capital.
Capital controls
government-imposed restrictions on the ability of CAPITAL to move in or out of a country. Examples include limits on foreign INVESTMENT in a country's FINANCIAL MARKETS, on direct investment by foreigners in businesses or property, and on domestic residents' investments abroad. Until the 20th century capital controls were uncommon, but many countries then imposed them. Following the end of the second world war only Switzerland, Canada and the United States adopted open capital regimes. Other rich countries maintained strict controls and many made them tougher during the 1960s and 1970s. This changed in the 1980s and early 1990s, when most developed countries scrapped their capital controls.
The pattern was more mixed in developing countries. Latin American countries imposed lots of them during the debt crisis of the 1980s then scrapped most of them from the late 1980s onwards. Asian countries began to loosen their widespread capital controls in the 1980s and did so more rapidly during the 1990s.
In developed countries, there were two main reasons why capital controls were lifted: free markets became more fashionable and financiers became adept at finding ways around the controls. Developing countries later discovered that foreign capital could play a part in financing domestic investment, from roads in Thailand to telecoms systems in Mexico, and, furthermore, that financial capital often brought with it valuable HUMAN CAPITAL. They also found that capital controls did not work and had unwanted side-effects. Latin America's controls in the 1980s failed to keep much money at home and also deterred foreign investment.
The Asian economic crisis and CAPITAL FLIGHT of the late 1990s revived interest in capital controls, as some Asian governments wondered whether lifting the controls had left them vulnerable to the whims of international speculators, whose money could flow out of a country as fast as it once flowed in. There was also discussion of a 'Tobin tax' on short-term capital movements, proposed by James TOBIN, a winner of the NOBEL PRIZE FOR ECONOMICS. Even so, they mostly considered only limited controls on short-term capital movements, particularly movements out of a country, and did not reverse the broader 20-year-old process of global financial and economic LIBERALISATION.
Capital flight
When CAPITAL flows rapidly out of a country, usually because something happens which causes investors suddenly to lose confidence in its economy. (Strictly speaking, the problem is not so much the MONEY leaving, but rather that investors in general suddenly lower their valuation of all the assets of the country.) This is particularly worrying when the flight capital belongs to the country’s own citizens. This is often associated with a sharp fall in the EXCHANGE RATE of the abandoned country’s currency.
Capital gains
The PROFIT from the sale of a capital ASSET, such as a SHARE or a property. Capital gains are subject to TAXATION in most countries. Some economists argue that capital gains should be taxed lightly (if at all) compared with other sources of INCOME. They argue that the less tax is levied on capital gains, the greater is the incentive to put capital to productive use. Put another way, capital gains tax is effectively a tax on CAPITALISM. However, if capital gains are given too friendly a treatment by the tax authorities, accountants will no doubt invent all sorts of creative ways to disguise other income as capital gains.
Capital intensive
A production process that involves comparatively large amounts of CAPITAL; the opposite of LABOUR INTENSIVE.
Capital markets
Markets in SECURITIES such as BONDS and SHARES. Governments and companies use them to raise longer-term CAPITAL from investors, although few of the millions of capital-market transactions every day involve the issuer of the security. Most trades are in the SECONDARY MARKETS, between investors who have bought the securities and other investors who want to buy them. Contrast with MONEY MARKETS, where short-term capital is raised.
Capital structure
The composition of a company’s mixture of DEBT and EQUITY financing. A firm’s debt-equity ratio is often referred to as its GEARING. Taking on more debt is known as gearing up, or increasing lever age. In the 1960s, Franco Modigliani and Merton Miller (1923–2000) published a series of articles arguing that it did not matter whether a company financed its activities by issuing debt, or equity, or a mixture of the two. (For this they were awarded the NOBEL PRIZE FOR ECONOMICS.) But, they said, this rule does not apply if one source of financing is treated more favourably by the taxman than another. In the United States, debt has long had tax advantages over equity, so their theory implies that American FIRMS should finance themselves with debt. Companies also finance themselves by using the PROFIT they retain after paying dividends.
Capitalism
The winner, at least for now, of the battle of economic 'isms'. Capitalism is a free-market system built on private ownership, in particular, the idea that owners of CAPITAL have PROPERTY RIGHTS that entitle them to earn a PROFIT as a reward for putting their capital at RISK in some form of economic activity. Opinion (and practice) differs considerably among capitalist countries about what role the state should play in the economy. But everyone agrees that, at the very least, for capitalism to work the state must be strong enough to guarantee property rights. According to Karl MARX, capitalism contains the seeds of its own destruction, but so far this has proved a more accurate description of Marx's progeny, COMMUNISM.
Cartel
An agreement among two or more FIRMS in the same industry to co-operate in fixing PRICES and/or carving up the market and restricting the amount of OUTPUT they produce. It is particularly common when there is an OLIGOPOLY. The aim of such collusion is to increase PROFIT by reducing COMPETITION. Identifying and breaking up cartels is an important part of the competition policy overseen by ANTITRUST watchdogs in most countries, although proving the existence of a cartel is rarely easy, as firms are usually not so careless as to put agreements to collude on paper. The desire to form cartels is strong. As Adam SMITH put it, 'People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public or in some contrivance to raise prices.
Catch-up effect
In any period, the economies of countries that start off poor generally grow faster than the economies of countries that start off rich. As a result, the NATIONAL INCOME of poor countries usually catches up with the national income of rich countries. New technology may even allow DEVELOPING COUNTRIES to leap-frog over industrialised countries with older technology. This, at least, is the traditional economic theory. In recent years, there has been considerable debate about the extent and speed of convergence in reality.
One reason to expect catch-up is that workers in poor countries have little access to CAPITAL, so their PRODUCTIVITY is often low. Increasing the amount of capital at their disposal by only a small amount can produce huge gains in productivity. Countries with lots of capital, and as a result higher levels of productivity, would enjoy a much smaller gain from a similar increase in capital. This is one possible explanation for the much faster GROWTH of Japan and Germany, compared with the United States and the UK, after the second world war and the faster growth of several Asian 'tigers', compared with developed countries, during the 1980s and most of the 1990s.
Central bank
A central bank sets short-term INTEREST RATES and oversees the health of the FINANCIAL SYSTEM, including by acting as LENDER OF LAST RESORT to commercial banks that get into financial difficulties. The Federal Reserve, the central bank of the United States, was founded in 1913. The Bank of England, known affectionately as the 'Old Lady of Threadneedle Street', was established in 1694, 26 years after the creation of the world's first central bank in Sweden. With the birth of the EURO in 1999, the MONETARY POLICY powers of the central banks of 11 European countries were transferred to a new EUROPEAN CENTRAL BANK, based in Frankfurt.
During the 1990s there was a trend to make central banks independent from political intervention in their day-to-day operations and allow them to set interest rates. Independent central banks should be able to concentrate on the long-term needs of an economy, whereas political intervention may be guided by the short-term needs of the GOVERNMENT. In theory, an independent central bank should reduce the risk of INFLATION. Some central banks are legally requried to set interest rates so as to hit an explicit inflation target. Politicians are often tempted to exploit a possible short-term trade-off between inflation and UNEMPLOYMENT, even though the long-term consequence of easing policy in this way is (most economists say) that the unemployment rate returns to what you started with and inflation is higher. An independent central bank, because it does not have to worry about persuading an electorate to vote for it, is more likely to act in the best long-run interests of the economy.
Ceteris paribus
Other things being equal. Economists use this Latin phrase to cover their backs. For example, they might say that “higher interest rates will lead to lower inflation, ceteris paribus”, which means that they will stand by their prediction about INFLATION only if nothing else changes apart from the rise in the INTEREST RATE.
Charity
“Bah! Humbug”, was Scrooge’s opinion of charitable giving. Some economists reckon charity goes against economic rationality. Some have argued that the popularity of charitable giving is proof that people are not economically rational. Others argue that it shows that ALTRUISM is something that people get pleasure (UTILITY) from, and so are willing to spend some of their INCOME on it. An interesting question is the extent to which the state is competing with private charity when it redistributes money from rich to poor or spends more on health care and whether this is inefficient.
Classical economics
The dominant theory of economics from the 18th century to the 20th century, when it evolved into NEO-CLASSICAL ECONOMICS. Classical economists, who included Adam SMITH, David RICARDO and John Stuart Mill, believed that the pursuit of individual self-interest produced the greatest possible economic benefits for society as a whole through the power of the INVISIBLE HAND. They also believed that an economy is always in EQUILIBRIUM or moving towards it.
Equilibrium was ensured in the LABOUR market by movements in WAGES and in the CAPITAL market by changes in the rate of INTEREST. The INTEREST RATE ensured that total SAVINGS in an economy were equal to total INVESTMENT. In DISEQUILIBRIUM, higher interest rates encouraged more saving and less investment, and lower rates meant less saving and more investment. When the DEMAND for labour rose or fell, wages would also rise or fall to keep the workforce at FULL EMPLOYMENT.
In the 1920s and 1930s, John Maynard KEYNES attacked some of the main beliefs of classical and neo-classical economics, which became unfashionable. In particular, he argued that the rate of interest was determined or influenced by the speculative actions of investors in BONDS and that wages were inflexible downwards, so that if demand for labour fell, the result would be higher UNEMPLOYMENT rather than cheaper workers.
Closed economy
An economy that does not take part in international trade; the opposite of an OPEN ECONOMY. At the turn of the century about the only notable example left of a closed economy is North Korea.
Collateral
An ASSET pledged by a borrower that may be seized by a lender to recover the value of a loan if the borrower fails to meet the required INTEREST charges or repayments.
Commoditisation
The process of becoming a COMMODITY. Microchips, for example, started out as a specialised technical innovation, costing a lot and earning their makers a high PROFIT on each chip. Now chips are largely homogeneous: the same chip can be used for many things, and any manufacturer willing to invest in some fairly standardised equip ment can make them. As a result, COMPETITION is fierce and PRICES and profit margins are low. Some economists argue that in today's economy the faster pace of innovation will make the process of commoditisation increasingly common.
Commodity
A comparatively homogeneous product that can typically be bought in bulk. It usually refers to a raw material - oil, cotton, cocoa, silver - but can also describe a manufactured product used to make other things, for example, microchips used in personal computers. Commodities are often traded on commodity exchanges. On AVERAGE, the PRICE of natural commodities has fallen steadily in REAL TERMS in defiance of some predictions that growing CONSUMPTION of non-renewables such as copper would force prices up. At times the oil price has risen sharply in real terms, most notably during the 1970s, but this was due not to the exhaustion of limited supplies but to rationing by the OPEC CARTEL, or war, or fear of it, particularly in the oil-rich Middle East.
Communism
The enemy of CAPITALISM and now nearly extinct. Invented by KARL MARX, who predicted that feudalism and capitalism would be succeeded by the 'dictatorship of the proletariat', during which the state would 'wither away' and economic life would be organised to achieve 'from each according to his abilities, to each according to his needs'. The Soviet Union was the most prominent attempt to put communism into practice and the result was conspicuous failure, although some modern followers of Marx reckon that the Soviets missed the point.
Comparative advantage
Paul Samuelson, one of the 20th century's greatest economists, once remarked that the principle of comparative advantage was the only big idea that ECONOMICS had produced that was both true and surprising. It is also one of the oldest theories in economics, usually ascribed to DAVID RICARDO. The theory underpins the economic case for FREE TRADE. But it is often misunderstood or misrepresented by opponents of free trade. It shows how countries can gain from trading with each other even if one of them is more efficient - it has an ABSOLUTE ADVANTAGE - in every sort of economic activity. Comparative advantage is about identifying which activities a country (or firm or individual) is most efficient at doing.
To see how this theory works imagine two countries, Alpha and Omega. Each country has 1,000 workers and can make two goods, computers and cars. Alpha's economy is far more productive than Omega's. To make a car, Alpha needs two workers, compared with Omega's four. To make a computer, Alpha uses 10 workers, compared with Omega's 100. If there is no trade, and in each country half the workers are in each industry, Alpha produces 250 cars and 50 computers and Omega produces 125 cars and 5 computers.
What if the two countries specialise? Although Alpha makes both cars and computers more efficiently than Omega (it has an absolute advantage), it has a bigger edge in computer making. So it now devotes most of its resources to that industry, employing 700 workers to make computers and only 300 to make cars. This raises computer output to 70 and cuts car production to 150. Omega switches entirely to cars, turning out 250.
World output of both goods has risen. Both countries can consume more of both if they trade, but at what PRICE? Neither will want to import what it could make more cheaply at home. So Alpha will want at least 5 cars per computer, and Omega will not give up more than 25 cars per computer. Suppose the terms of trade are fixed at 12 cars per computer and 120 cars are exchanged for 10 computers. Then Alpha ends up with 270 cars and 60 computers, and Omega with 130 cars and 10 computers. Both are better off than they would be if they did not trade.
This is true even though Alpha has an absolute advantage in making both computers and cars. The reason is that each country has a different comparative advantage. Alpha's edge is greater in computers than in cars. Omega, although a costlier producer in both industries, is a less expensive maker of cars. If each country specialises in products in which it has a comparative advantage, both will gain from trade.
In essence, the theory of comparative advantage says that it pays countries to trade because they are different. It is impossible for a country to have no comparative advantage in anything. It may be the least efficient at everything, but it will still have a comparative advantage in the industry in which it is relatively least bad.
There is no reason to assume that a country's comparative advantage will be static. If a country does what it has a comparative advantage in and sees its INCOME grow as a result, it can afford better education and INFRASTRUCTURE. These, in turn, may give it a comparative advantage in other economic activities in future.
Competition
The more competition there is, the more likely are FIRMS to be efficient and PRICES to be low. Economists have identified several different sorts of competition. PERFECT COMPETITION is the most competitive market imaginable in which everybody is a price taker. Firms earn only normal profits, the bare minimum PROFIT necessary to keep them in business. If firms earn more than this (excess profits) other firms will enter the market and drive the price level down until there are only normal profits to be made.
Most markets exhibit some form of imperfect or MONOPOLISTIC COMPETITION. There are fewer firms than in a perfectly competitive market and each can to some degree create BARRIERS TO ENTRY. Thus firms can earn some excess profits without a new entrant being able to compete to bring prices down.
The least competitive market is a MONOPOLY, dominated by a single firm that can earn substantial excess profits by controlling either the amount of OUTPUT in the market or the price (but not both). In this sense it is a price setter. When there are few firms in a market (OLIGOPOLY) they have the opportunity to behave as a monopolist through some form of collusion (see CARTEL). A market dominated by a single firm does not necessarily have monopoly power if it is a CONTESTABLE MARKET. In such a market, a single firm can dominate only if it produces as efficiently as possible and does not earn excess profits. If it becomes inefficient or earns excess profits, another more efficient or less profitable firm will enter the market and dominate it instead.
Competitiveness
'Real economists don't talk about competitiveness,' said Paul Krugman, a much-respected contemporary economist. Real businessmen and real politicians talk about it all the time, however. Many FIRMS have undergone savage downsizing to remain competitive, and governments have set up numerous committees to examine how to sharpen their countries' economic performance.
Mr Krugman's objection was not to the use of the term competitiveness by companies, which often do have competitors that they must beat, but to applying it to countries. At best, it is a meaningless word when applied to national economies; at worst, it encourages PROTECTIONISM. Countries, he claimed, do not compete in the same way as companies. When two companies compete, one's gain is the other's loss, whereas international trade, Mr Krugman argued, is not a ZERO-SUM GAME: when two countries compete through trade they both win.
Yet measures of national competitiveness are not complete nonsense. A country's future prosperity depends on its GROWTH in PRODUCTIVITY, which GOVERNMENT policies can influence. Countries do compete in that they choose policies to promote higher living standards. Even so, conceptual and measurement difficulties mean that the growing number of indices purporting to compare the competitiveness of different countries should probably be taken with a large pinch of salt.
Complementary goods
When you buy a computer, you will also need to buy software. Computer hardware and software are therefore complementary goods: two products, for which an increase (or fall) in DEMAND for one leads to an increase (fall) in demand for the other. Complements are the opposite of SUBSTITUTE GOODS. For instance, Microsoft Windows-based personal computers and Apple Macs are substitutes.
Concentration
The tendency of a market to be dominated by a few big FIRMS. A high degree of concentration may be evidence of ANTITRUST problems, if it reflects a lack of COMPETITION. Traditionally, economists examined whether there was too much concentration using the HERFINDAHL-HIRSCHMAN INDEX, which is determined by adding the squares of the market shares of all firms involved. A low Herfindahl indicated many competitors and thus great difficulty in exercising MARKET POWER; a high Herfindahl, however, suggested a concentrated market in which PRICE rises are easier to sustain. More recently, antitrust authorities have placed less emphasis on concentration. One reason is that it is hard to define the market in which concentration should be measured. Instead, antitrust authorities have turned their attention to finding examples of firms earning excessive profits or holding back INNOVATION, although this too raises tricky conceptual and practical questions.
Conditionality
When there are strings attached, for example, to INTERNATIONAL AID or loans from the IMF or WORLD BANK. The delivery of the MONEY may be made subject to the GOVERNMENT of the country implementing economic or political reforms desired by the donor or lender.
Consumer confidence
How good consumers feel about their economic prospects. Measures of average consumer confidence can be a useful, though not infallible, indicators of how much consumers are likely to spend. Combined with measures such as business confidence, it can shed light on overall levels of economic activity.
Consumer prices
What people are usually thinking of when they worry about INFLATION. The PRICES paid by whoever finally consumes goods or SERVICES, as opposed to prices paid by FIRMS at various stages of the production process .
Consumer surplus
The difference between what a consumer would be willing to pay for a good or service and what that consumer actually has to pay. Added to PRODUCER SURPLUS, it provides a measure of the total economic benefit of a sale.
Consumption
What consumers do. Within an economy, this can be broken down into private and public consumption . The more resources a society consumes, the less it has to save or invest, although, paradoxically, higher consumption may encourage higher INVESTMENT. The LIFE-CYCLE HYPOTHESIS suggests that at certain stages of life individuals are more likely to be saving than consuming, and at other stages they are more likely to be heavy consumers. Some economists argue that consumption taxes are a more efficient form of TAXATION than taxes on wealth, CAPITAL, property or INCOME.
Contestable market
A market in which an inefficient firm, or one earning excess profits, is likely to be driven out by a more efficient or less profitable rival. A market can be contestable even if it is dominated by a single firm, which appears to enjoy a MONOPOLY with MARKET POWER, and the new entrant exists only as potential COMPETITION.
Corruption
Being corrupt is not just bad for the soul, it also harms the economy. Research has found that in countries with a lot of corruption, less of their GDP goes into INVESTMENT and they have lower GROWTH rates. Corrupt countries invest less in education, a sector of the economy that pays big economic dividends but small bribes, than do clean countries, thereby reducing their HUMAN CAPITAL. They also attract less FOREIGN DIRECT INVESTMENT.
There is no such thing as good corruption, but some sorts of corruption are less bad than others. Some economists point to similarities between bribery and paying taxes or buying a licence to operate. Where it is predictable - where the briber knows what to pay and can be sure of getting what it pays for--corruption harms the economy far less than where it is capricious.
The absence of corruption has huge economic benefits, however, by allowing the development of institutions that enable a market economy to function efficiently. In many of the world's more corrupt countries, the distinction between private interest and public duty is still unfamiliar. Countries that have made graft the exception rather than the rule in the conduct of public affairs have been helped to grow by the emergence of institutions such as an independent judiciary, a free press, a well-paid civil service and, perhaps crucially, an economy in which FIRMS have to compete for customers and CAPITAL.
Cost of capital
The amount a firm must pay the owners of CAPITAL for the privilege of using it. This includes INTEREST payments on corporate DEBT, as well as the dividends generated for shareholders. In deciding whether to proceed with a project, FIRMS should calculate whether the project is likely to generate sufficient revenue to cover all the costs incurred, including the cost of capital. Calculating the cost of EQUITY capital can be tricky.
Cost-benefit analysis
A method of reaching economic decisions by comparing the costs of doing something with its benefits. It sounds simple and common-sensical, but, in practice, it can easily become complicated and is much abused. With careful selection of the assumptions used in cost-benefit analysis it can be made to support, or oppose, almost anything. This is particularly so when the decision being con templated involves some cost or benefit for which there is no market PRICE or which, because of an EXTERNALITY, is not fully reflected in the market price. Typical examples would be a project to build a hydroelectric dam in an area of outstanding natural beauty or a law to require factories to limit emissions of gases that may cause ill-health.
Credit creation
Making loans. Often the amount of credit creation is subject to REGULATION. Lenders may have limits on the amount of loans they can make relative to the ASSETS they have, so that they run little RISK of BANKRUPTCY (see Basel 1 and 2 and CAPITAL ADEQUACY RATIO). A CENTRAL BANK tries to keep the amount of credit creation below the level at which it would increase the MONEY SUPPLY so much that INFLATION accelerates. This was never easy to get right even when most lending was by BANKS, but it has become much harder with the recent growth of non-bank lending, such as by credit-card companies and retailers.
Credit crunch
When BANKS suddenly stop lending, or BOND market LIQUIDITY evaporates, usually because creditors have become extremely RISK AVERSE.
Creditor
A lender, whether by making a loan, buying a BOND or allowing MONEY owed now to be paid in the future.
Crony capitalism
An approach to business based on looking after yourself by looking out for your own. At least until the crisis of the late 1990s, some Asian companies, and even governments, were notable for awarding contracts only to family and friends. This was often a form of CORRUPTION, resulting in economic inefficiency.
Crowding out
When the state does something it may discourage, or crowd out, private-sector attempts to do the same thing. At times, excessive GOVERNMENT borrowing has been blamed for low private-sector borrowing and, consequently, low INVESTMENT and (because the economic returns on public borrowing are typically lower than those on private DEBT, especially corporate debt) slower economic GROWTH. This has become less of a concern in recent years as government indebtedness has declined and, because of GLOBALISATION, FIRMS have become more able to raise CAPITAL outside their home country. Crowding out may also come from state spending on things that might be provided more efficiently by the private sector, such as health care, or even through CHARITY, redistribution.
Currency board
A means by which some countries try to defend their currency from speculative attack. A country that introduces a currency board commits itself to converting its domestic currency on demand at a fixed EXCHANGE RATE. To make this commit ment credible, the currency board holds RESERVES of foreign currency (or GOLD or some other liquid ASSET) equal at the fixed rate of exchange to at least 100% of the value of the domestic currency that is issued.
Unlike a conventional CENTRAL BANK, which can print MONEY at will, a currency board can issue domestic notes and coins only when there are enough foreign exchange reserves to back it. Under a strict currency board regime, INTEREST RATES adjust automatically. If investors want to switch out of domestic currency into, say, US dollars, then the SUPPLY of domestic currency will automatically shrink. This will cause domestic interest rates to rise, until eventually it becomes attractive for investors to hold local currency again.
Like any fixed exchange rate system, a currency board offers the prospect of a stable exchange rate and its strict discipline also brings benefits that ordinary exchange rate pegs lack. Profligate governments, for instance, cannot use the central bank's printing presses to fund large deficits. Hence currency boards are more credible than fixed exchange rates. The downside is that, like other fixed exchange rate systems, currency boards prevent governments from setting their own interest rates.
If local inflation remains higher than that of the country to which the currency is pegged, the currencies of countries with currency boards can become overvalued and uncompetitive. Governments cannot use the exchange rate to help the economy adjust to an outside SHOCK, such as a fall in export prices or sharp shifts in capital flows. Instead, domestic WAGES and prices must adjust, which may not happen for many years, if ever.
A currency board can also put pressure on banks and other financial institutions if interest rates rise sharply as investors dump local currency. For emerging markets with fragile banking systems, this can be a dangerous drawback. Furthermore, a classic currency board, unlike a central bank, cannot act as a LENDER OF LAST RESORT. A conventional central bank can stem a potential banking panic by lending money freely to banks that are feeling the pinch. A classic currency board cannot, although in practice some currency boards have more freedom than the classic description implies. The danger is that if they use this freedom, governments may cause currency speculators and others to doubt the government's commitment to living within the strict disciplines imposed by the currency board.
Argentina's decision to devalue the peso amid economic and political crisis in January 2002, a decade after it adopted a currency board, showed that adopting a currency board is neither a panacea nor a guarantee that an exchange rate backed by one will remain fixed come what may.
Currency peg
When a GOVERNMENT announces that the EXCHANGE RATE of its currency is fixed against another currency or currencies.
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