The Little Book of Economics Part 2

You may think unemployment is a simple concept, but the official definition is quite precise: you have to be available and have looked for work in the four weeks before the government takes it survey. You do not, however, have to be collecting unemployment insurance. By that measure, there were 15.3 million unemployed people in November 2009, for an unemployment rate of 10 percent.

There are alternative measures of unemployment. That same month (November 2009), 2.3 million more people were available but hadn't looked for work in the last four weeks; almost a million more had simply given up looking because they concluded no work was available, and 9.2 million were working part time because they couldn't find full-time work. Including all these people produces an under underemployment rate, or as the pros call it, the U-6 unemployment rate, U-6 unemployment rate, of 17.2 percent. of 17.2 percent.

If the payroll and household reports show employment going in opposite directions, which should you trust? Usually, the payroll survey because its sample is much larger. If the two reports show a persistent divergence in employment levels, it's a clue one is missing something important.

.The employment report can leave you scratching your head. For instance, you may hear that in one month employment fell, which is bad, but so did the unemployment rate, which is good. Why might this happen? There are two main reasons.

1. Partic.i.p.ation Bounces Around. Partic.i.p.ation Bounces Around. Some people counted as unemployed (and therefore part of the labor force) one month may not be in the next, because they gave up looking for work, went back to school, or retired. When unemployment falls because of a drop in partic.i.p.ation, it is usually a bad sign. Conversely, if unemployment rises because of higher partic.i.p.ation, it is a good sign. Some people counted as unemployed (and therefore part of the labor force) one month may not be in the next, because they gave up looking for work, went back to school, or retired. When unemployment falls because of a drop in partic.i.p.ation, it is usually a bad sign. Conversely, if unemployment rises because of higher partic.i.p.ation, it is a good sign.2. Sometimes the Two Surveys Diverge. Sometimes the Two Surveys Diverge. The payroll report may find fewer jobs while the household report finds more people employed. This can happen because employment surveys, like opinion polls, have margins of error, and different results are normal, statistical noise. Or it may also result from the fact that the two surveys define The payroll report may find fewer jobs while the household report finds more people employed. This can happen because employment surveys, like opinion polls, have margins of error, and different results are normal, statistical noise. Or it may also result from the fact that the two surveys define employment employment differently. Someone working two jobs is counted twice in the payroll survey but just once in the household survey. Nannies, farm workers, and the self-employed are counted in the household survey but not in the payroll survey. differently. Someone working two jobs is counted twice in the payroll survey but just once in the household survey. Nannies, farm workers, and the self-employed are counted in the household survey but not in the payroll survey.If the two surveys go in different directions, which should you trust? Usually, the payroll survey because its sample is much larger, and its job count is constantly revised as more complete information is received. But the payroll survey doesn't tell you anything about the unemployed or the characteristics of workers themselves. For that, you have to turn to the household survey. If the two reports show a persistent divergence in employment levels, it's a clue one is missing something important.

Another important job market indicator is the number of new claims that states receive for unemployment insurance. Because the U.S. Labor Department reports total new claims each Thursday, this number is one of the earliest indicators of a s.h.i.+ft in the health of the economy. The numbers are volatile, though. Holidays and bad weather can play havoc with the trend.

The Job Market of Tomorrow In the 2000s, the natural rate of unemployment was probably around 5 percent. By the end of the decade, the actual unemployment rate was 10 percent. Will we ever get back, or close, to that 5 percent rate? The path is strewn with obstacles.

Many of the jobs lost in 2007-2009 are never coming back. In 1982, about 22 percent of the unemployed were on temporary layoff, and businesses called many back to work when sales recovered. In 2009, though, only 11 percent were on temporary layoff; for two-thirds of the unemployed, the job they lost was gone permanently. What explains those permanent losses? Well, many of the now-unemployed owed their jobs to the housing boom-construction workers, tradesmen, mortgage brokers, and so on. Even when the housing market recovers, a lot of those people won't be needed.

Another factor holding back employment is that some people can't move to a new job because their homes are worth less than their mortgage. Unless they can come up with a lot of extra cash to pay off the mortgage, or default, they're tied to their homes until values recover.

A final damper on job creation is that the longer someone is unemployed, the more their skills and habits waste away, making it harder to ever go back to work. Even when the economy has recovered, some of those people will struggle to go back to work.

The future structure of the workforce is changing as people tend to work later into their lives. For decades, a growing share of workers over the age of 55 retired before reaching 65; now, however, more are staying in the labor force. Incentives in Social Security and company pensions to retire early have now reversed, and people need to work longer to keep the lifestyle they want. It's also because work itself has changed. Someone who inhaled noxious vapors on a factory floor often couldn't work much past age 55, much less want to. But nowadays we teach or consult, we don't plough fields or mine coal, and we stay healthy longer. Not only can many of us work longer, many of us want to.

As a result of these factors, the natural rate of unemployment, previously around 5 percent, will probably rise in coming years, perhaps even as high as 6 percent.

The Bottom Line * In the short run, the number of jobs rises and falls with the business cycle. In the long run, though, the growth in jobs usually tracks almost perfectly the growth in the number of people who want jobs.* The unemployment rate is the single best signpost of the economy's health. When the economy reaches full strength, the unemployment reaches its so-called natural natural rate. rate.* Pay usually tracks productivity, which is why, over the years, workers have gotten richer. In recent decades, however, the best-paid workers have seen their salaries grow much more rapidly than the rest of the work force has, because of the premium on skills, weaker unions, and superstar salaries, whether for lawyers or for athletes.

Chapter Five.

Fire and Ice Warning: Inflation and Deflation Are Toxic to Your Economic Health WHEN YUGOSLAVIA dissolved into a b.l.o.o.d.y civil war in the 1990s, there were more than just ethnic and religious rivalries at work. Inflation, the continuous rise in the prices of almost everything, was also a factor. Thanks to an economic crisis in the early 1980s, prices in Yugoslavia were rising at annual rates of more than 1,200 percent by the late 1980s. Inflation helped dissolve the cohesion of Yugoslavia's multi-ethnic middle cla.s.s. Some people protected themselves by growing their own food or h.o.a.rding foreign currency. Others watched their incomes and savings get wiped out.

Throughout history, high inflation has often led to social upheaval. Hyperinflation, when prices rise by 50 percent per month, helped bring the n.a.z.is to power in Germany and the communists in Russia and China, and topple both civilian and military governments in Argentina. These, of course, are extreme forms of the disease. But far more modest rates of inflation in the 1970s helped drive Labor from power in Britain and Jimmy Carter from the White House.

Why is inflation so destabilizing?

Prices are the market's air supply; they signal surpluses and shortages and tell businesses and consumers when to produce more or consume less. Inflation contaminates this air supply. Suppose you are thinking of opening a new hotel in a city where rates are rising 10 percent, thinking that must be a sign of strong demand. But what if the cost of land is going up 12 percent, linen by 11 percent, chambermaid and doormen wages by 13 percent? The new hotel may actually lose money. Inflation makes it hard to interpret price signals.

Inflation also unsettles people because it arbitrarily punishes some people while it rewards others. A retiree who buys a government bond that pays 4 percent interest, only to see inflation jump to 5 percent, sees his purchasing power get clobbered. A home buyer lucky enough to lock in a mortgage at 5 percent and then sees home prices soar 50 percent scores a windfall.

Inflation is also a hidden tax. As wages rise to compensate for it, so does tax revenue, making it easier for the government to repay what it borrowed before inflation took off. In the process, however, it robs the currency in people's wallets of purchasing power.

Another reason inflation is unsettling is that getting it back down is painful. Governments may resort to wage and price controls or other heavy-handed interventions to reduce inflation. Usually, though, it takes a recession to cure inflation-and that hurts everyone.

Goldman Sachs economists have shown that investors do best under low inflation (see Table 5.1 Table 5.1). Under high inflation, only stocks gain, and not by much. Under hyperinflation, everything goes down.

Table 5.1 Investors Hate Inflation and Deflation Investors Hate Inflation and Deflation Source: Goldman Sachs Global Economics Paper #190, September, 2009. Goldman Sachs Global Economics Paper #190, September, 2009.

Inflation's dangers should not be overstated. It is hard to find evidence that steady inflation below 5 percent does much economic harm. The trouble is that as inflation rises it gets less predictable. This year 5 percent, next year who knows?

From Cigarettes to Aztecs There are two competing schools of thought on the cause of inflation, and listening to their proponents is like listening to creationists and Darwinians argue over how life began. Monetarists blame the money supply, money supply, while neo-Keynesians blame a combination of while neo-Keynesians blame a combination of excess spending and inflationary psychology. excess spending and inflationary psychology. There's truth to both schools. There's truth to both schools.

Blame It on the Money Supply Milton Friedman, the n.o.bel economist, said "Inflation is always and everywhere a monetary phenomenon."

There are two competing schools of thought on the causes inflation. Listening to them is like listening to creationists and Darwinians argue over how life began.

.Monetarism, as this brand of economics is called, blames inflation on too much money chasing too few goods. Intuitively, this makes sense. If you double the amount of money people spend on stuff, but leave unchanged the amount of stuff, prices will double. as this brand of economics is called, blames inflation on too much money chasing too few goods. Intuitively, this makes sense. If you double the amount of money people spend on stuff, but leave unchanged the amount of stuff, prices will double.

In its most basic form, this notion is uncontroversial, and economists of all stripes accept it. Let's examine one example. In German prisoner-of-war camps, prisoners used cigarettes as currency, pricing bread, s.h.i.+rts, and chocolates in cigarettes. When Red Cross s.h.i.+pments arrived, suddenly everyone had more cigarettes to spend-and the prices of everything went up. As the cigarettes wore out or were smoked, prices started dropping again. Altering the supply of money has the same effect. A government normally finances its spending with taxes or by selling bonds to the public. Suppose, instead, it sells the bonds to the central bank, which pays for them by creating money out of thin air. This can produce hyperinflation, hyperinflation, when prices rise 50 percent or more when prices rise 50 percent or more per month. per month. In 2008 in Zimbabwe, prices were doubling roughly every day. Steven Hanke, a Johns Hopkins University economist, figures annual inflation equaled 89.7 s.e.xtillion percent (that's 897 followed by 20 zeros). During such hyperinflations, people try to hold as little currency as possible. As soon as they're paid, they spend the money before its value is wiped out. In many cases, people switch to foreign currency instead. In 2008 in Zimbabwe, prices were doubling roughly every day. Steven Hanke, a Johns Hopkins University economist, figures annual inflation equaled 89.7 s.e.xtillion percent (that's 897 followed by 20 zeros). During such hyperinflations, people try to hold as little currency as possible. As soon as they're paid, they spend the money before its value is wiped out. In many cases, people switch to foreign currency instead.

At the opposite extreme, fixing the money supply eradicates persistent inflation. That's what happens when a country goes on the gold standard, gold standard, which means that the currency is backed by gold. You could take your notes to a bank and receive their face value in gold. Prices could rise, but eventually, they'd fall again. When the United States was on the gold standard between 1790 and 1911, periods of inflation and deflation alternated; wholesale prices ended the period roughly where they began. which means that the currency is backed by gold. You could take your notes to a bank and receive their face value in gold. Prices could rise, but eventually, they'd fall again. When the United States was on the gold standard between 1790 and 1911, periods of inflation and deflation alternated; wholesale prices ended the period roughly where they began.

Under some conditions, though, the money supply can rise even with a gold standard in place. How? The supply of gold may increase. For example, when Spanish conquerors brought troves of Aztec and Inca treasures back to Europe, a century of mild inflation ensued. Or, another way this can happen is if the government allows the same amount of gold to back a larger amount of currency. Roman emperors and medieval kings routinely debased their coins-that is, they reduced their gold or silver content-to finance their wars. In 1933-1934, Franklin D. Roosevelt allowed gold to rise from $20.67 to $35 per troy ounce, a 41 percent devaluation, in a successful effort to end deflation.

Thus far, the link between the money supply and inflation is straightforward. It's when you get to the case of a modern economy that the monetarist theory, while good in theory, proves almost useless in practice. Let's examine why.

The central bank doesn't control the entire money supply, only a narrow portion of it: specifically, the notes, coins, and reserves it supplies to commercial banks. (Reserves are cash that banks keep on deposit at the Fed to settle payments with each other, with the Treasury, or to exchange for currency to refill their ATMs.) are cash that banks keep on deposit at the Fed to settle payments with each other, with the Treasury, or to exchange for currency to refill their ATMs.) To understand why the link between money supply and inflation is muddy, imagine that the Fed distributes $1 trillion in freshly printed twenty-dollar bills to people on street corners. If they promptly rush home and stuff the money under their mattresses, what will happen to consumer spending and inflation? Zilch. For money to cause inflation, it must be lent and spent. Banks lend when they have healthy balance sheets and a lot of eager, creditworthy customers. Consumers spend when they feel confident about their jobs and salaries; they go to the ATM more often, run up bigger credit cards bills, remodel their homes, and buy faster cars.

Monetarists claim that growth in the money supply leads to more spending and more inflation. Actually, it's the other way around. Every dollar consumers borrow or spend returns to the banking system and shows up in someone else's checking or savings deposit or money market mutual fund, which are all part of the broader money supply (which has labels like M1, M2, and M3).

For this reason, the Fed doesn't target the money supply. It uses its control of reserves only to ensure banks have enough cash to keep their ATMs full, and to control short-term interest rates. (I'll explain how it does this in Chapter Ten.) Therefore, its influence over the broad money supply is indirect. If it raises interest rates, it will dampen spending and, eventually, the money supply. If, however, the economy is truly moribund, because no one wants to lend or borrow, the Fed can drive interest rates to zero and print gobs of money without causing broader measures of money and credit to grow. That's what happened in 2009: The Fed had lowered rates to almost zero and increased reserves to banks by $1 trillion, yet total bank lending contracted.

The Other Side of the Story: Mind the Gap and Your Mind So save some trouble and don't preoccupy yourself with the money supply. For a more realistic picture of inflation-the neo-Keynesian picture-think instead of hotels in Scottsdale, Arizona. The supply of rooms is roughly the same all year, but there's a lot more demand in January when the temperature averages 70 degrees than in July when it averages 100 degrees. The demand for rooms is higher in January, and so, not surprisingly, the hotel can charge a lot more than it would in July.

The same is true for the economy as a whole: When demand for all goods and services runs ahead of the supply (i.e., potential output), inflation rises. When demand falls short of potential, inflation falls. When unemployment is below its natural rate, workers are better able to win raises. This relations.h.i.+p was captured by Alban William Phillips, a New Zealand economist. The Phillips Curve, which shows an inverse relations.h.i.+p between unemployment and inflation, is at the heart of the neo-Keynesian inflation model.

A hotel whose occupancy suddenly rises to 95 percent from 80 percent will eventually add rooms, but will first simply charge more. Similarly, if occupancy falls, the hotel may eventually close. But first, it will simply charge less. The difference between actual gross domestic product (GDP) and potential GDP is the output gap, output gap, which you could think of as a vacancy rate for the entire economy. Inflation always falls after recessions because the output gap is so large: hotels and office buildings are empty, factories are idle, and the unemployed are everywhere. which you could think of as a vacancy rate for the entire economy. Inflation always falls after recessions because the output gap is so large: hotels and office buildings are empty, factories are idle, and the unemployed are everywhere.

The surest sign the economy has exceeded its capacity is if firms are paying higher wages to attract qualified workers. Inflation needs a wage- price spiral; if wages don't rise, there's no spiral.

.Like the natural rate of unemployment, potential output is a slippery thing to measure. It's easy to tell if a hotel, factory, or power plant is at full capacity. But what about a law firm or an Internet dating service? Potential also changes. In the early 1970s, high oil prices rendered a lot of existing factories obsolete; this reduced potential. In the late 1990s, companies found they could use the computers and the Internet to boost production with fewer workers. For example, airlines replaced reservation agents with web sites. This boosted potential.

Globalization has also relaxed the constraints on capacity. A company that interprets X-rays can't charge as much if a compet.i.tor offers to do it using Indian radiologists at a fraction of what U.S. radiologists cost.

It is difficult to know when the economy has exceeded its capacity, but there are telltale signs. The surest sign is if firms are paying higher wages to attract qualified workers. Inflation needs a wage-price spiral; if wages don't rise, there's no spiral.

An economy with a large output gap can grow rapidly with little threat of inflation, just as a near-empty hotel that manages to boost occupancy to 50 percent is still in no position to raise room rates. But once the output gap has been closed, the economy can only grow in line with the labor force and productivity. For the United States, that means a growth rate between 2.25 percent and 2.75 percent.

Strange as it may seem, inflation also depends a lot on what people think think it will be. Suppose an employer and its union sit down to hammer out a new contract. If both parties agree inflation will be 2 percent, they will quickly agree to a 2 percent cost-of-living increase and the firm will plan on setting prices to cover those costs. If every firm in the country and its employees do the same thing, inflation will settle at 2 percent. Thus, expectations of inflation can be self-fulfilling. it will be. Suppose an employer and its union sit down to hammer out a new contract. If both parties agree inflation will be 2 percent, they will quickly agree to a 2 percent cost-of-living increase and the firm will plan on setting prices to cover those costs. If every firm in the country and its employees do the same thing, inflation will settle at 2 percent. Thus, expectations of inflation can be self-fulfilling.

Rapidly s.h.i.+fting expectations lead to quicker changes in inflation. If a jump in oil prices suddenly boosts the cost of living, firms and workers quickly raise wages and prices to compensate, and a wage-price spiral ensues. This means that the tradeoff between inflation and unemployment in the Phillips Curve is only temporary. Pus.h.i.+ng the economy past its potential can drive down unemployment for a little while, but as inflation picks up, so will workers' wage demands, and unemployment will return to where it was.

On the other hand, if people have gotten used to 2 percent inflation year in and year out, they might endure a jump in oil prices without expecting wages to automatically follow. Well-anch.o.r.ed expectations can keep inflation steady even when the economy is above or below potential.

Even Worse than Inflation Inflation is a familiar scourge. Deflation, when prices are falling, is rarer and, potentially, nastier. This may seem odd. Shouldn't we be happy if the prices we pay go down year after year? Well, it's sort of like weight loss. What's the reason for it: you're eating better and exercising more (good), or starving to death (bad)?

Good deflation occurs when workers and companies become more productive and learn to make things at a lower cost. Intel, for example, is continuously cutting the price of computer chips because it keeps finding new, cheaper ways to make them. Intel's profits and its employees' salaries still go up. If you multiply that across the entire economy, it's possible for prices to fall across the board even as incomes rise.

Bad deflation occurs when spending collapses and companies have to cut their prices to prop up sales, just as hotels cut their rates when tourist traffic dries up. Once people expect falling prices, they hold off on purchases. Workers initially resist pay cuts, so employers must lay some off to cope with falling prices. Eventually, fear of unemployment persuades workers to accept lower pay. Prices and wages follow each other down, the mirror image of an inflationary wage-price spiral. We saw this happen between 1929 and 1933 in the United States when prices fell 7 percent per year. j.a.pan has endured a milder form of this bad deflation since the late 1990s.

If prices and wages are falling at the same rate, is anyone the worse for it? After all, paychecks are smaller, but purchasing power is the same because prices have fallen. The problem is that debt is fixed so as incomes and prices fall, the burden of debts rises. Homeowners slash spending to keep up with their mortgage payments. Or worse, the homeowner goes into foreclosure because the home may not be worth enough to repay the loan. The bank fails, deepening the economic stress. "The more the economic boat tips, the more it tends to tip," wrote Irving Fisher, the American economist who labeled this phenomenon debt-deflation debt-deflation in 1933. in 1933.

Deflation can be harder to cure than inflation. Faced with inflation, a central bank that wants to can generally raise interest rates as high as needed. Faced with recession, it can stimulate spending and restore growth by lowering its interest rate below the inflation rate, making the real cost of borrowing negative. negative. Clearly, that's impossible when inflation itself is negative, since the central bank can't lower interest rates below zero: During deflation the real interest rate will always be positive. (In Chapter Ten, I'll describe other tools the central bank can use if it's already lowered short-term rates to zero.) Clearly, that's impossible when inflation itself is negative, since the central bank can't lower interest rates below zero: During deflation the real interest rate will always be positive. (In Chapter Ten, I'll describe other tools the central bank can use if it's already lowered short-term rates to zero.) The People's Choice In the wake of the Great Recession, a weird schizophrenia has overcome the economics fraternity. It was nicely encapsulated in a country-and-western You Tube ditty1 by Merle Hazard, the pseudonym of Jon Shayne, a money manager: by Merle Hazard, the pseudonym of Jon Shayne, a money manager: Inflation or deflation, tell me if you can: will we become Zimbabwe or will we be j.a.pan?

In the long run, inflation is a political choice.

.So, which will it be? Probably, neither. Yet there are risks on both sides. The Great Recession left so much unused economic capacity that inflation, already low, could cross the line into deflation.

In the long run, though, inflation is a political choice. When society won't pay the taxes necessary to meet its own demands to create jobs, provide social programs, or fight wars, government has to borrow and may pressure the central bank to keep interest rates low to help with that borrowing. That would eventually lead to inflation. In the extreme, the government may simply order the central bank to print the money, which can lead to hyperinflation.

It sounds tempting, but don't a.s.sume politicians will succ.u.mb. Voters hate inflation. In the 1970s, people consistently rated inflation a bigger concern than unemployment in Gallup polls. In a 1996 study, Robert s.h.i.+ller, a Yale University economist, found that if forced to choose, Americans, Germans, and Brazilians all preferred higher unemployment to higher inflation. Thus, if inflation rises, politicians will eventually be forced to tame it or find a central banker who will. Jimmy Carter and Ronald Reagan, for instance, stood by as the Fed induced two savage recessions to break the back of inflation.

Into the Weeds When the Bureau of Labor Statistics (BLS) was created in the late nineteenth century, the cost of living was one of the first things it tried to measure. Today, the consumer price index (CPI) is the economic statistic that most affects Americans' daily lives since it is used to calculate cost-of-living adjustments. Once a month, BLS statisticians and contractors fan out across the country, and visit thousands of businesses to collect prices on over 80,000 items in 200 categories from new cars to funerals. It uses regular surveys of consumers' spending habits to a.s.sign a weight to each category in the index-32 percent for shelter, 0.3 percent for sugar and candy. The 12-month percentage change in the CPI is the most common measure of inflation.

Fresh food and energy account for many of the monthly swings in the CPI. Because an increase one month is often undone a few months later, economists regularly exclude food and energy. The remainder, or core inflation, provides a more stable picture of underlying inflation. This picture will be misleading, though, if energy and food costs march steadily higher (or lower) over time instead of reverting to their old levels.

The CPI isn't flawless. Consumers are constantly s.h.i.+fting to stores that have cheaper prices-to Wal-Mart, for example, from pricey department stores, and to cheaper products, such as Internet telephone calls instead of landline calls. The CPI tries to capture these changes by surveying consumers' spending habits every two years, but in between, it may slightly overstate inflation.

The CPI's measure of home owners.h.i.+p is also controversial. It's not a measure of home prices. Rather, it's a measure of what a homeowner would pay to rent the same house. The two prices usually move together, but not always. Between 1998 and 2007, home prices rose 84 percent but because rents were much less buoyant, the CPI recorded only a 38 percent increase in the cost of owning a home.

There are other inflation measures, including: * PCE Index. PCE Index. An important but little-known alternative to the CPI is the An important but little-known alternative to the CPI is the price index of personal consumption expenditures, price index of personal consumption expenditures, or or PCE index, PCE index, which the Bureau of Economic a.n.a.lysis uses to calculate GDP. The Federal Reserve's forecasts are based on the PCE index rather than the CPI. The PCE is based on what businesses actually sell rather than what consumers say they buy (which may be flawed). As a result, it a.s.signs less importance to housing than the CPI, and more to medical care. The PCE index has quirks, too-it puts a price on things that have no price, like Sunday ma.s.s and no-fee checking accounts. which the Bureau of Economic a.n.a.lysis uses to calculate GDP. The Federal Reserve's forecasts are based on the PCE index rather than the CPI. The PCE is based on what businesses actually sell rather than what consumers say they buy (which may be flawed). As a result, it a.s.signs less importance to housing than the CPI, and more to medical care. The PCE index has quirks, too-it puts a price on things that have no price, like Sunday ma.s.s and no-fee checking accounts.* GDP Deflator GDP Deflator. The GDP deflator GDP deflator measures prices paid by all sectors of the economy: businesses, government, foreign buyers of exports, as well as consumers. It's used to calculate how much of an increase in nominal GDP is due to inflation and how much is real activity. measures prices paid by all sectors of the economy: businesses, government, foreign buyers of exports, as well as consumers. It's used to calculate how much of an increase in nominal GDP is due to inflation and how much is real activity.* Producer Price Index. Producer Price Index. The The producer price index producer price index (PPI) measures the prices that sellers receive, rather than what consumers pay. While it tracks prices for some services, like transportation and health, its main attraction is its index of finished goods, which excludes services and intermediate goods like the rubber and steel that eventually go into cars. Because it excludes services, the PPI is a much narrower measure of inflation than the CPI, and it is much more volatile. (PPI) measures the prices that sellers receive, rather than what consumers pay. While it tracks prices for some services, like transportation and health, its main attraction is its index of finished goods, which excludes services and intermediate goods like the rubber and steel that eventually go into cars. Because it excludes services, the PPI is a much narrower measure of inflation than the CPI, and it is much more volatile.* Import Price Index. Import Price Index. The The import price index import price index tracks what we spend on imported goods, and thus signals inflationary or deflationary pressure from abroad or from the dollar's exchange value. tracks what we spend on imported goods, and thus signals inflationary or deflationary pressure from abroad or from the dollar's exchange value.Gold and commodity prices are much better measures of the fear fear of inflation than as of inflation than as predictors predictors of inflation. of inflation.

* Inflation Expectations. Inflation Expectations. These expectations can be monitored through surveys. Each month, the Thomson Reuters/University of Michigan Surveys of Consumers asks consumers what they expect inflation to be over the next year, and the next 5 to 10 years. Treasury inflation-protected securities (TIPS) provide a minute-by-minute measure of investors' inflation expectations. If a TIPS bond yields 3 percent and a regular bond yields 5 percent, the difference, 2 percent, is the expected inflation rate. Be cautious with this because numerous technical factors push these yields around. These expectations can be monitored through surveys. Each month, the Thomson Reuters/University of Michigan Surveys of Consumers asks consumers what they expect inflation to be over the next year, and the next 5 to 10 years. Treasury inflation-protected securities (TIPS) provide a minute-by-minute measure of investors' inflation expectations. If a TIPS bond yields 3 percent and a regular bond yields 5 percent, the difference, 2 percent, is the expected inflation rate. Be cautious with this because numerous technical factors push these yields around.* Gold and Commodity Prices. Gold and Commodity Prices. Many investors look to gold and commodity prices for early warning signs of inflation and deflation. These prices are much better measures of the Many investors look to gold and commodity prices for early warning signs of inflation and deflation. These prices are much better measures of the fear fear of inflation than as of inflation than as predictors predictors of inflation. That's partly because so many other things affect them. Gold responds to global unrest, the demand for jewelry, and the dollar. Commodity prices respond to the strength of the global economy, strikes, and bad weather. of inflation. That's partly because so many other things affect them. Gold responds to global unrest, the demand for jewelry, and the dollar. Commodity prices respond to the strength of the global economy, strikes, and bad weather.* Wages and Labor Costs. Wages and Labor Costs. Hourly and weekly wages can be tracked each month in the BLS's payroll survey that I discussed in Chapter Four. The quarterly Hourly and weekly wages can be tracked each month in the BLS's payroll survey that I discussed in Chapter Four. The quarterly employment cost index employment cost index is more comprehensive because it also includes benefits and bonuses. Benefits for health care, pensions, and payroll taxes are now almost 20 percent of compensation, up from 5 percent in the 1940s. Still, to determine if rising wages are inflationary, you have to compare them to productivity. If a painter's salary doubles because he can now paint twice as much with a paint sprayer, his salary per square foot has not risen at all. Labor costs, adjusted for productivity, are measured through is more comprehensive because it also includes benefits and bonuses. Benefits for health care, pensions, and payroll taxes are now almost 20 percent of compensation, up from 5 percent in the 1940s. Still, to determine if rising wages are inflationary, you have to compare them to productivity. If a painter's salary doubles because he can now paint twice as much with a paint sprayer, his salary per square foot has not risen at all. Labor costs, adjusted for productivity, are measured through unit labor costs, unit labor costs, which the BLS reports quarterly along with productivity. which the BLS reports quarterly along with productivity..

The Bottom Line * High inflation is destabilizing and corrosive; deflation can be destructive. The best inflation is not too high nor too low: from 1 percent to 3 percent seems about right.* The money supply is a lousy guide to where inflation is going. Better, instead, to monitor how far the economy is operating from its capacity. For example, if unemployment is 5 percent, it doesn't have much spare capacity left. Wages are the best evidence of an economy running out of capacity. If wages aren't rising, a wage-price spiral can't happen.* Inflation is more likely to rise if people expect it to, because they'll adjust their wage and price behavior accordingly. Stable inflation expectations are a bulwark against both inflation and deflation.

Chapter Six.

Drop the Puck!

The Globalization Game Is Here Whether We're Ready or Not IN THE SUMMER of 2006, Israel fought a fierce, one-month war with Hezbollah. Israeli jets pounded southern Lebanon while Hezbollah rained rockets on northern Israel, sending residents into bomb shelters and emptying the beaches, stores, and port of Haifa, one of Israel's largest cities. Yet Israel's stock market was higher when the war was over than when it began. That year Israel's economy grew 5 percent and its currency soared.

Why so little harm to the country's economy amidst so much destructive violence? In a word: globalization. globalization. Israel's economy is led by advanced technology companies whose markets are the rest of the world. Just before the war, Warren Buffett acquired Iscar Metal-working Company, a precision metal-cutting tool maker. It was. .h.i.t by a rocket but never missed a s.h.i.+pment. During the war, Hewlett Packard made one of the largest ever acquisitions of a predominantly Israeli high-tech company. Israel's economy is led by advanced technology companies whose markets are the rest of the world. Just before the war, Warren Buffett acquired Iscar Metal-working Company, a precision metal-cutting tool maker. It was. .h.i.t by a rocket but never missed a s.h.i.+pment. During the war, Hewlett Packard made one of the largest ever acquisitions of a predominantly Israeli high-tech company.

Globalization is the increased flow of goods, services, people, ideas, and capital across borders. As economies merge with each other, interest rates in one country respond to the whims of investors an ocean away, local companies' sales depend on the tastes of foreign consumers, and local consumers can choose from a cornucopia of foreign and domestic offerings. As such, globalization means a lot is riding on the skills of a country's own citizens. If they produce something the world wants, their ability to serve a far larger market translates into higher productivity and salaries. It also leaves a country at the mercy of the rest of the world's health. Israel didn't have a banking crisis but because its major trading partners did, it followed them into recession in 2009.

A Gravitational Pull from Afar When you study economic growth, jobs, and interest rates you have to keep in mind that globalization is exerting an often hidden influence, the way a distant planet's gravitational pull alters another planet's...o...b..t. Local business and consumers could be doing fine, but if the global economy is sickly then U.S. exports will be weak, affecting jobs, incomes, and growth at home. Americans' wages will be tugged up or down by what workers making the same thing earn in other countries. The price of gasoline is subject to how much oil China and India consume. And policies Congress wants for favored industries may be dropped because they violate world trade rules.

The best yardstick of this growing interdependence is in the remarkable expansion of global trade. Since 1950, global trade has outstripped world gross domestic product (GDP) growth by 6 percent to 4 percent, according to the World Trade Organization (WTO).2 Exports account for more than 40 percent of China's, Germany's, and Israel's GDP, and more than 80 percent of Ireland's. Even in the United States, which depends less on trade because of its gigantic internal market, exports have risen from 5 percent of GDP in the 1960s to 11 percent in the 2000s. That number should head higher as U.S. firms seek their fortunes among the emerging markets' nouveau riche consumers instead of hunkered down Americans. Exports account for more than 40 percent of China's, Germany's, and Israel's GDP, and more than 80 percent of Ireland's. Even in the United States, which depends less on trade because of its gigantic internal market, exports have risen from 5 percent of GDP in the 1960s to 11 percent in the 2000s. That number should head higher as U.S. firms seek their fortunes among the emerging markets' nouveau riche consumers instead of hunkered down Americans.

We usually think the benefit of international trade is more exports. But that's a blinkered view. Imports are just as important, perhaps more important, because they enrich consumers. Think of all the things you'd forsake if borders were closed: fresh fruit and tropical flowers in the dead of winter, British novelist J.K. Rowling's Harry Potter novels, cheap oil from Saudi Arabia (okay, a mixed blessing), Hyundais.

Countries even benefit by importing something they could make themselves. Why do parents hire a nanny when they could stay home and raise the child themselves? Because it lets them earn the money to buy a nicer home and send the child to college. The same principle of comparative advantage comparative advantage is why rich countries buy toys and clothing from poor countries: so that their own workers can earn more building aircraft, conducting heart bypa.s.s operations, or making movies. is why rich countries buy toys and clothing from poor countries: so that their own workers can earn more building aircraft, conducting heart bypa.s.s operations, or making movies.

Yet, comparative advantage doesn't explain why many countries export and import similar things. For example, why does France sells Renaults to Germany while Germany exports Volkswagens to France? Why don't the French stick to buying Renaults and Germans to Volkswagens? Because consumers like choice. Just as your town has numerous pizzerias catering to different tastes in pizza, French and German consumers want to choose from more than just a few brands of car.

Giving consumers this much choice would be impossible without globalization. Cars require huge economies of scale to make cheaply and a single country's market by itself can't support more than a few brands. When global barriers come down, numerous small national markets become a big global market that numerous companies can now profitably serve. Singapore and Luxembourg are tiny countries but are among the richest because their companies and consumers are part of a global market. The compet.i.tion inevitably improves the quality of the domestic product, such as when a flood of j.a.panese imports forced U.S. manufacturers to improve their own quality.

The expansion of trade from things we drop on our foot to things we carry around in our brains terrifies many Americans.

It's Complicated To economists, the benefits of both exports and imports are so obvious that it's one of the few things this notoriously fractious profession agrees on. Yet, in recent years, trade has changed radically, rattling even normally stalwart supporters. Traditionally, we bought toys, clothing, and other things from poor countries that required more manual and less intellectual labor. We bought more advanced products like aircraft, software, and microprocessor chips from other rich countries.

But in recent decades, China, India, and Russia have joined the global workforce and now sell the sorts of advanced products we long thought were invulnerable to such compet.i.tion. The collapsing cost of blasting megabytes of data across undersea cables makes it possible for foreigners to read Americans' X-rays, take their hotel reservations, or report on town council meetings. Alan Blinder, a former vice-chairman of the Federal Reserve, has estimated that perhaps a quarter of U.S. jobs can now be done offsh.o.r.e.

This expansion of trade from things we drop on our foot to things we carry around in our brains terrifies many Americans who fear that even the most advanced jobs will disappear at the hands of foreign compet.i.tion. Just consider the storm of criticism that greeted Gregory Mankiw, a Harvard professor who, while serving as chairman of George Bush's Council of Economic Advisers in 2004, said outsourcing was just as beneficial as traditional trade. The Republican Speaker of the House, Dennis Hastert, accused Mankiw of failing a "basic test of real economics."3 But, Mankiw was right. While cheaply written software from India may put some U.S. programmers out of work, it makes U.S. consumers of software better off. Cheap software may help some U.S. companies develop products that they can then sell abroad. This then enables the company to hire the laid off programmers in a new capacity.

That so many Americans are fearful of outsourcing is understandable. Why, they might imagine, would anyone pay them (or a j.a.panese or British worker) more than a Chinese or Indian worker with the same university degree? The reason is that a U.S. worker's productivity comes not just from her own education and skill but the social, economic, and political infrastructure around her: the advanced equipment she uses, the cables that transmit her telephone and Internet traffic free of static and brownouts across the country and back, highways that get her and her coworkers to the office and their products to market, trustworthy courts that enforce contracts and settle disputes with customers and suppliers.

While trade does not rob Americans of jobs, it alters the balance between winners and losers.

.Expanded trade in services plays to the United States' strength-about one-third of our exports are already services from Hollywood films to engineering, architectural, and financial services. The Shanghai World Financial Center, which on completion in 2007 became China's tallest skysc.r.a.per, was designed by Kohn Pedersen Fox, a New York-based architecture firm that gets 50 to 85 percent of its business outside the United States. Apple's iPod is a.s.sembled in China, but much of the finished product's designs, components, marketing and value were added elsewhere. Indeed, according to a study by the Personal Computing Industry Centre at the University of California, Irvine, just 2 percent of all the wages earned in the sale of an iPod are earned in China, while 70 percent are earned in the United States. When Apple sells an iPod in Germany, it shows up as an export from China, but most of the benefit flows back to the United States.

There's a caveat to this story, though. Trade does not make Americans collectively poorer, but it does alter the balance between winners and losers. the balance between winners and losers. In the case of the iPod, the winners, besides Americans who buy iPods, are clearly Steve Jobs and Apple's employees. The people who sell the iPod in U.S. stores aren't really affected. Their jobs don't require high skills but they're also relatively insulated from overseas compet.i.tion. The losers are the people who may have a.s.sembled iPods in the United States but can't compete with the low wages paid to factory workers in China. Trade can thus aggravate inequality, eroding wages for formerly middle-cla.s.s workers while rewarding those at the top. In the case of the iPod, the winners, besides Americans who buy iPods, are clearly Steve Jobs and Apple's employees. The people who sell the iPod in U.S. stores aren't really affected. Their jobs don't require high skills but they're also relatively insulated from overseas compet.i.tion. The losers are the people who may have a.s.sembled iPods in the United States but can't compete with the low wages paid to factory workers in China. Trade can thus aggravate inequality, eroding wages for formerly middle-cla.s.s workers while rewarding those at the top.

A Question of Balances: Trade Deficits and Surpluses Trade has expanded over time because: * Consumers around the world are getting more affluent and want more choices.* The cost of getting stuff across the ocean has plummeted thanks to jet engines, the s.h.i.+pping container, and the fact that valuable things weigh less these days: some don't weigh anything at all and can be zapped across fiber optic cables.* Barriers to trade have fallen steadily.Even as exports and imports grow over time, though, countries may swing from a trade surplus-that is, from exporting more than it imports-to a trade deficit and back, because of short-term influences, including: * How Healthy a Country and Its Trading Partners Are. How Healthy a Country and Its Trading Partners Are. If European consumers are sickly and U.S. consumers are robust, the United States will import a lot from Europe but its exports to Europe will suffer, which will widen the U.S. trade deficit. If European consumers are sickly and U.S. consumers are robust, the United States will import a lot from Europe but its exports to Europe will suffer, which will widen the U.S. trade deficit.* The Terms of Trade. The Terms of Trade. The relative prices of a country's exports and imports also influence trade deficits. If you own an apartment in a neighborhood that suddenly becomes fas.h.i.+onable, you can raise the rent without investing a dime on renovations. Similarly, a country blessed with resources the rest of the world wants reaps a windfall. Russia's trade surplus soared in the 2000s because soaring demand made its oil more valuable. The reverse is also true. Like a tenant whose rent doubles because his neighborhood has gentrified, the United States had to pay more for oil in the 2000s because it was so much in demand by other countries. The relative prices of a country's exports and imports also influence trade deficits. If you own an apartment in a neighborhood that suddenly becomes fas.h.i.+onable, you can raise the rent without investing a dime on renovations. Similarly, a country blessed with resources the rest of the world wants reaps a windfall. Russia's trade surplus soared in the 2000s because soaring demand made its oil more valuable. The reverse is also true. Like a tenant whose rent doubles because his neighborhood has gentrified, the United States had to pay more for oil in the 2000s because it was so much in demand by other countries.Some countries run deficits year after year while others run surpluses.

This reflects different saving and spending habits.