Deadweight cost/loss
The extent to
which the value and impact of a tax, tax relief or subsidy is reduced because
of its side-effects. For instance, increasing the amount of tax levied on
workers’ pay will lead some workers to stop working or work less, so reducing
the amount of extra tax to be collected. However, creating a tax relief or
subsidy to encourage people to buy life insurance would have a deadweight cost
because people who would have bought insurance anyway would benefit.
Debt
'Neither a
borrower nor a lender be,' wrote shakespeare in 'hamlet'. Actually, the
availability of debt, and the willingness to take it on, is a crucial
ingredient of economic growth, because it allows individuals, firms and
governments to make investments they would not otherwise be able to afford. The
price of debt is interest. Until recently, lending was an activity dominated by
banks (although mortgages for individuals buying their homes have long been
available from special housing savings institutions). Since the 1960s, debt has
become increasingly available from other sources. Companies have sold trillions
of dollars worth of bonds to investors in the financial markets. Individuals
have been able to borrow with credit cards, and for those who have nowhere else
to turn there are pawn shops and loan sharks, which charge very high rates of
interest. Total private-sector debt in 2003 was around 150% of gdp in the
united states, compared with less than 100% in 1928. In most countries, by far
the biggest single borrower is the state, through the national debt.
Debt forgiveness
Cancelling or
rescheduling a borrower's debts to lessen the pain of the debt burden. Debt
forgiveness is increasingly viewed as the best way to relieve the financial
problems facing poorer countries. Some of these countries have to pay so much
in interest each year to foreign lenders that they have little money left to
spend on the long-term solutions to their poverty, such as educating their
workers and building a modern infrastructure. In 1998 the world bank calculated
that around 40 of the world's poorest countries had an 'unsustainably high'
debt burden: the present value of their total debts was more than 220% of their
exports.
Debt forgiveness
has potential drawbacks. For instance, there is a risk of moral hazard. If
countries that borrow too much are let off their financial obligations, poor
countries may feel they have nothing to lose by borrowing as much as they can.
This is why policymakers often argue that debt forgiveness should come with a
conditionality clause, for instance, a requirement that countries have a track
record of implementing economic reforms designed to prevent a repeat of the
errors that first created the need for debt forgiveness. This is the approach
taken by the world bank's hipc (highly indebted poor country) initiative,
launched in 1996 and expanded in 1999. However, by 2003, only eight of the 38
poor countries eligible under the programme had made enough progress in reform
to have some debt forgiven.
Default
Failure to fulfil
the terms of a loan agreement. For example, a borrower is in default if he or
she does not make scheduled interest payments on a loan or fails to pay off the
loan at the agreed time. Judging the likelihood of default is a crucial part of
pricing a loan. Interest rates are set so that, on average , a portfolio of
loans will be profitable to the creditor , even if some individual loans are
loss-making as a result of borrowers defaulting.
Deficit
In the red – when
more money goes out than comes in. A budget deficit occurs when public spending
exceeds government revenue. A current account deficit occurs when exports and
inflows from private and official transfers are worth less than imports and
transfer outflows (see balance of payments).
Deflation
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.
Demand
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 modelling 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
hasbeen especially successful in practice, particularly when attempting to
manage short-term demand through fine tuning.
Demand curve
A graph showing
the relationship between the price of a good and the amount of demand for it at
different prices.
Demographics
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 stockmarket 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 maximising 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.
Deposit insurance
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.
Depreciation
A fall in the
value of an asset or a currency; the opposite of appreciation.
Depression
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 stockmarket 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 stockmarket 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 stabilise 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.
Deregulation
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 liberalisation
based on substantial amounts of deregulation hand-in-hand with the
privatisation 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.
Derivatives
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.
Devaluation
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).
Developing countries
A euphemism for
the world's poor countries, also known, often optimistically, as emerging
economies. Some four-fifths of the world's 6 billion people already live in
developing countries, many of them in abject poverty. Developing countries
account for less than one-fifth of total world gdp.
Economists
disagree about how likely--and how fast--developing countries are to become
developed. Neo-classical economics predicts that poor countries will grow
faster than richer ones. The reason is diminishing returns on capital. Since
poor countries start with less capital, they should reap higher returns than a
richer country with more capital from each slice of new investment. But this
catch-up effect (or convergence) is not supported by the data. For one thing,
there is, in fact, no such thing as a typical developing country. The official
developing world includes the (sometimes) fast-growing asian tigers and the
poorest nations in africa. Studies of the relationship between growth and gdp
per head in rich and poor countries found no evidence that poorer countries
grew faster. Indeed, if anything, poorer countries have grown more slowly.
Development
economics has argued that this is because poor countries have unique problems
that require different policy solutions from those offered by conventional
developed-world economics. But new endogenous growth theory instead argues that
there is conditional convergence. Hold constant such factors as a country's
fertility rate, its human capital and its government policies (proxied by the
share of current government spending in gdp), and poorer countries generally
grow faster than richer ones. Since, in reality, other factors are not constant
(not all countries have the same level of human capital or the same government
policies), absolute convergence does not happen.
Government
policies seem to be crucial. Countries with broadly free-market policies - in
particular, free trade and the maintenance of secure property rights--have raised
their growth rates. (although some economists argue that the asian tigers are
an exception to this free-market rule.) Open economies have grown much faster
on average than closed economies. Higher public spending relative to gdp is
usually associated with slower growth. Furthermore, high inflation is bad for
growth and so is political instability. The poorest countries can indeed catch
up. Their chances of doing so are maximised by policies that give a greater
role to competition and incentives, at home and abroad.
Despite starting
with a big disadvantage, there is evidence that some developing countries do
not help themselves because they squander the resources they have. Institutions
that produce effective governance of an economy are crucial. Those countries
that use their resources well can grow quickly. Indeed, the world's
fastest-growing economies are a small subgroup of exceptional performers among
the poor countries.
Development economics
Spawned by the end
of the colonial era in the 1950s and 1960s, a whole branch of economic theory
grew up around the question of how to promote economic development in poor
countries. The proposition on which development economics was built was that
poor countries were intrinsically different from rich ones and so needed their
own set of economic models. Some development economists argued, for instance,
that the self-interested, rational individual (homo economicus) did not exist
in traditional tribal societies. They claimed that because many poor countries
had large agricultural populations and were often dependent on a few commodity
exports for foreign exchange earnings, economic policies that suited rich
countries would not work for them. With hindsight, much of this was misguided,
and policies based on it had disastrous effects. Development economists
believed that the state had to play a big role in fostering modernisation.
Instead, the result was huge, inefficient bureaucracies riddled with
corruption, massive budget deficits and rampant inflation. During the 1990s,
most governments of developing countries started to reverse these policies and
undo the damage they had done by introducing policies based on similar economic
models to those that had worked in rich countries. However, the sequencing of
these new policies seemed to make a big difference to how well they worked.
Doing the right things in the right order is crucial.
Diminishing returns
The more you have,
the smaller is the extra benefit you get from having even more; also known as
diseconomies of scale (see economies of scale). For instance, when workers have
a lot of capital giving them a little more may not increase their productivity
anywhere near as much as would giving the same amount to workers who currently
have little or no capital. This underpins the catch-up effect, whereby there is
(supposedly) convergence between the rates of growth of developing countries
and developed ones. In the new economy, some economists argue, capital may not
suffer from diminishing returns, or at least the amount of diminishing will be
much smaller. There may even be ever increasing returns.
Direct taxation
Taxes levied on
the income or wealth of an individual or company. Contrast with indirect
taxation. In much of the world, direct tax rates fell during the 1980s and
1990s, partly because some economists argued that high rates of tax on income
discouraged people from working, and that high rates of tax on profit
encouraged companies to move to countries with lower rates. Furthermore, high
rates of income tax were viewed as politically unpopular. Even so, although
rates were cut, because both personal income and corporate profits grew
steadily throughout this period the total amount collected via direct taxation
continued to rise. Economists often disagree about which of direct taxes or
indirect taxes are the least inefficient method of taxation.
Discount rate
The rate of
interest charged by a central bank when lending to other financial
institutions. It also refers to a rate of interest used when calculating
discounted cashflow.
Discounted cash flow
How much less is a
sum of money due in the future worth today? The answer is found by discounting
the future cashflow, using an interest rate that reflects the fact that money
in future is worth less than money now, because money now could be invested and
earn interest, whereas future money cannot. Firms use discounted cashflow to
judge whether an investment project is worthwhile. The interest rate is a means
of reflecting the opportunity cost of tying up money in the investment project.
To test whether an investment makes economic sense the income must be
discounted so that it can be measured against the costs. If the present value
of the benefits exceeds the costs, the investment is a good one.
Disequilibrium
When supply and
demand in a market are not in balance. Contrast with equilibrium.
Disinflation
A fall in the rate
of inflation. This means a slower increase in prices but not a fall in prices,
which is known as deflation.
Disintermediation
Cutting out the
middleman. Disintermediation has become a buzz word in financial services in
particular, as competitive and technological changes have done away with the
need for established intermediaries. Banks have seen much of their business
slip away, such as lending to companies that now tap capital markets direct.
New economy theorists argued that many retailers would be disintermediated as
the internet enabled customers to transact directly with producers without
needing to visit a shop. But this has happened more slowly than they predicted.
Diversification
Not putting all
your eggs in one basket. Investors are encouraged to do this by modern
portfolio theory, as holding several different shares and other assets helps to
reduce risk. At the sharp end of business, however, diversification is somewhat
out of fashion. Economic studies of diversifying corporate mergers have found
that these often hurt the shareholders of the acquiring firm; by contrast,
diversified firms that have sold off non-core businesses have typically made
their shareholders much better off.
Dividend
The part of a
company’s profit distributed to shareholders. Unlike interest on debt, the
payment of a dividend is not automatic. It is decided by the company’s
managers, subject to the approval of the company’s owners (shareholders).
However, when a company cuts its dividend, this usually triggers a sharp fall
in its share price by more than would be appear to be justified by the reduced
dividend. Economists theorise that this is because a dividend cut signals to
shareholders that the company is in a bad way, with more bad news to follow.
Division of labour
People are better
off specialising than trying to be jacks of all trades and ending up masters of
none. The logic of dividing the workforce into different crafts and professions
is the same as that underpinning the case for free trade: everybody benefits
from doing those things in which they have a comparative advantage and using
income from doing so to meet their other needs.
Dollarisation
When a country's
own money is replaced as its citizens' preferred currency by the us dollar.
This can be a deliberate government policy or the result of many private
choices by buyers and sellers (for instance, at the first sign of trouble,
investors across latin america generally flee into dollars). When it is
government policy, dollarisation is, in essence, a beefed up currency board.
The appeal of
dollarisation is that the value of the dollar is more stable than the
distrusted local currency, which may well have a history of suddenly falling in
value. By eliminating all possible risk of devaluation against the dollar, the
cost of local companies' and the government's borrowing in international
markets is reduced, as the currency risk is removed. A big downside is that the
country hands over control of monetary policy to the federal reserve, and the
right interest rate for the united states may not be appropriate for the
dollarised country, if that country and the united states do not constitute an
optimal currency area. This is one reason that in some countries the local
currency has been displaced by another fairly stable currency, such as, in some
central european economies, the euro (and before that the d-mark).
Dominant firm
A firm with the
ability to set prices in its market (see monopoly, oligopoly and antitrust).
Dumping
Selling something
for less than the cost of producing it. This may be used by a dominant firm to
attack rivals, a strategy known to antitrust authorities as predatory pricing.
Participants in international trade are often accused of dumping by domestic
firms charging more than rival imports. Countries can slap duties on cheap
imports that they judge are being dumped in their markets. Often this amounts
to thinly disguised protectionism against more efficient foreign firms.
In practice,
genuine predatory pricing is rare - certainly much rarer than anti-dumping
actions - because it relies on the unlikely ability of a single producer to
dominate a world market. In any case, consumers gain from lower prices; so do
companies that can buy their supplies more cheaply abroad.
