The Little Book of Economics.

How the Economy Works in the Real World.

by G. Ip.

Foreword.

IT WAS AS A 15-year-old at school in England that I was formally introduced to the subject of economics. And I immediately fell in love with it. Here was a subject that provided me with valuable tools to think about a range of topics, to formulate answers from first principles, and to pose additional interesting questions whose answers I was also eager to know.

My love affair with economics has blossomed and continues today. And I feel privileged as economics seems to be even more relevant and topical as time pa.s.ses. It facilitates our understanding of the well-being of societies; it explains many of the daily interactions between individuals, companies, and governments; and it offers a guide to understanding the political and social trends that are shaping our world.

Simply put, economics is the key to understanding and a.n.a.lyzing both what is likely to happen and what should happen. Yet, as a topic, it is also horribly misunderstood and often overlooked.

Many believe that economics is too complex, too mathematical, and too arcane for them. Others question the benefits of investing their time and effort to get to know a subject that is the source of endless jokes, including presidential ones. (For example, President Harry S. Truman is said to have famously asked for a one handed economist, noting that "all my economists say, on the one hand and on the other.") Why am I telling you all this? Because I have come across a book that makes economics brilliantly accessible and, also, lots of fun (yes, economics can be fun!).

Forget about those heavy textbooks. Instead, read Greg Ip's book. It is well written and highly engaging. Moreover, this book could not have been written by a more qualified person; and it could not come at a better time.

Greg first came to my attention, and that of my professional colleagues, through his reporting and a.n.a.lyses at the Wall Street Journal. Wall Street Journal. We would all eagerly look forward to his columns for insights into economic developments and the outlook for policy. We would all eagerly look forward to his columns for insights into economic developments and the outlook for policy.

Greg's work at the Wall Street Journal, Wall Street Journal, and now and now The Economist, The Economist, is based on careful, in-depth research. It uses a robust set of a.n.a.lytical frameworks and reflects access to top policymakers and thinkers. And it is always relevant and timely. His columns have been the catalyst for interesting discussions at PIMCO's Investment Committee as we all tried to better understand developments and detail our shared outlook for the economy and markets. is based on careful, in-depth research. It uses a robust set of a.n.a.lytical frameworks and reflects access to top policymakers and thinkers. And it is always relevant and timely. His columns have been the catalyst for interesting discussions at PIMCO's Investment Committee as we all tried to better understand developments and detail our shared outlook for the economy and markets.

In his elegant book, Greg takes us on an informative and stimulating economic journey. We make multiple stops as we get exposed to basic topics (such as the drivers of economic growth and welfare) and delicate balances (such as the tug of war between inflation and deflation). We learn about how government actions impact the economy-be it through the familiar channel of public finances and interest rates, or the more complex web of regulations and prudential supervision.

The book offers us a wonderful mix of perspectives. We are treated to broad overview a.n.a.lyses that are reminiscent of looking at the landscape from a plane flying at 30,000 feet in a cloudless sky. We are also exposed to careful micro discussions, finding ourselves, as Greg puts it, "inside the sausage factory."

As you would expect, Greg's book also includes delightful discussions of one of his favorite topics-namely, the design and operation of monetary policy. We get a rare view into the mysterious world of the U.S. Federal Reserve where technocratic competence has to be combined with political savvy and judgment calls about the inherently uncertain balance of future risks and opportunities.

The book also provides us with numerous examples of how all this a.n.a.lysis applies to companies and people that are familiar to most of us. Indeed, the frequent real world snippets and text boxes are a great reminder of how economics plays out every day in the world around us.

Greg did more that produce an elegant book. He did so at a great time.

The global economy today is in a multiyear process of resetting after the 2008-2009 global financial crisis. This historical phenomenon is full of unfamiliar dynamics. It constantly questions "conventional wisdom" and it proceeds in a highly uneven and b.u.mpy fashion.

No wonder economics features so prominently on the front pages of daily newspapers around the world. In industrial countries, there are frequent reports on the unusual level and composition of unemployment, the explosion in public debt and deficits, the volatility of exchange rates, the prospect for higher taxation, and the still fragile state of the banking system. In major emerging economies, you will find numerous articles on the sustainability of their development breakout phases, on controlling inflation and a.s.set bubbles, and on resisting protectionist pressures from abroad.

Greg a.s.sembles and a.n.a.lyzes these pressing themes in a work that is as much a guidebook for our times as an explainer of economics. His brilliant book will help you identify and understand the economic forces that are dramatically reshaping the globe today, and having a major impact on our social and political outlook. It will expose you to the key issues in an engaging and enjoyable fashion. Even seemingly old hands like me will end up learning and re-learning critical aspects of this fascinating and relevant topic.

I hope that you enjoy this book as much as I did. It's a must-read for all those wishing to understand what today's world holds in store for them, for their children, and for their grandchildren.

-Mohamed El-Erian

Introduction.

IN THE SUMMER of 2009 the cover of The Economist The Economist portrayed an economics textbook melting into a puddle. "Of all the economic bubbles that have been p.r.i.c.ked, few have burst more spectacularly than the reputation of economics itself," it said. portrayed an economics textbook melting into a puddle. "Of all the economic bubbles that have been p.r.i.c.ked, few have burst more spectacularly than the reputation of economics itself," it said.

That same summer, Paul Krugman, the n.o.bel prize-winning economist, surveyed the wreckage of the global economy and declared that most macroeconomics-the study of the broad economy-of the last 30 years was "spectacularly useless at best, and positively harmful at worst."

For those of us whose job is to watch the economy, the last few years have been a trial by fire. Just a few years ago, we supposedly had it all figured out. Steady growth and low inflation were here to stay and nasty recessions were a thing of the past. Like the bathroom plumbing, the broad economy was something people didn't think about because it worked fine. Who could blame the folks who watch over our economy, like central bankers, for being a bit smug?

We've now seen the worst crisis and the deepest recession since the 1930s, and unprecedented government firepower unleashed in response. It's been a Galapagos Islands of economic exotica: central banks out of interest-rate bullets reaching for their monetary bayonets, debt crises stalking rich and poor countries, fear of inflation side by side with fear of deflation. The smiles have been wiped off the experts' faces. The public's indifference to the economy has been replaced by rapt attention and, let's face it, a lot of fear.

With such a turbulent and uneasy global economy, clear explanations of what's going on are vital. Yet, most people find economics shrouded in jargon and dry numbers. The Little Book of Economics The Little Book of Economics provides the solution. provides the solution.

Telling the story of our economy has been my stock in trade for 20 years now. At newspapers in Canada, then at the Wall Street Journal, Wall Street Journal, and now and now The Economist, The Economist, I've followed markets, talked to workers, visited businesses, and got to know central bankers. Then I've explained to readers and listeners in plain, simple terms, what's going on in the economy, why, and how it affects them. I've followed markets, talked to workers, visited businesses, and got to know central bankers. Then I've explained to readers and listeners in plain, simple terms, what's going on in the economy, why, and how it affects them.

I was introduced to economics as a child. My mother, a practicing economist, now retired, delighted in trying to apply what she knew about the dismal science to her four children's upbringing. We must have been the only kids in town whose weekly allowance was indexed to inflation. I took economics in college, though not intending to write about it; I just wanted a fallback in case journalism didn't work out. Right out of college, I joined a metropolitan daily newspaper that put me on the night shift covering local politics, crime, and the like, a lot of which never made it into the paper. The business section, however, had lots of s.p.a.ce in it and regular hours, so I got a transfer. Soon, I was writing about the economy and the markets, and loving it.

In the process, I discovered a chasm between the economics taught in college and the real world. Textbooks go on about the money supply but it turns out central banks ignore it. Simple questions like "how big is the national debt?" have complicated answers. I learned about fiscal policy but not about debt crises.

So I wrote this book with those lessons in mind. This is not a book for PhD economists, but for the citizen and investor on Main Street. I've explained the essential concepts with real life examples and a.n.a.logies, and shown the forces behind the news and events of the last two years. I've left out the dense and unappealing jargon. If only the world would do the same! But of course, in the world of economics you will run into jargon, so I've prepared you by putting a section called "Into the Weeds" in most chapters. By the phrase "into the weeds," I mean the internal guts of the economy: the data, the people, the lingo. Don't be frightened by these sections; they are perfect primers for anyone who wants to follow the markets and the economy in detail. Finally, I've boiled down everything in each chapter into "The Bottom Line." If you read nothing else in the chapter, read this: it will tell you the essentials in a few short sentences.

There's much more to economics than what I could put into The Little Book of Economics The Little Book of Economics so please visit my web site, so please visit my web site, www.gregip.com, where you'll find a more complete list of sources used in this book, suggestions for further reading, more of my own articles, and answers to questions about things this book discusses.

We've been through a lot of economic trauma in the last few years, but economics still offers essential tools for understanding it. This book will put those tools in your hands.

Chapter One.

The Secrets of Success

How People, Capital, and Ideas Make Countries Rich POP QUIZ: The year is 1990. Which of the following countries has the brighter future?

The first country leads all major economies in growth. Its companies have taken commanding market shares in electronics, cars, and steel, and are set to dominate banking. Its government and business leaders are paragons of long-term strategic thinking. Budget and trade surpluses have left the country rich with cash.

The second country is on the brink of recession, its companies are deeply in debt or being acquired. Its managers are obsessed with short-term profits while its politicians seem incapable of mustering a coherent industrial strategy.

You've probably figured out that the first country is j.a.pan and the second is the United States. And if the evidence before you persuaded you to put your money on j.a.pan, you would have been in great company. "j.a.pan has created a kind of automatic wealth machine, perhaps the first since King Midas," Clyde Prestowitz, a prominent pundit, wrote in 1989, while the United States was a "colony-in-the-making." Kenneth Courtis, one of the foremost experts on j.a.pan's economy, predicted that in a decade's time it would approach the U.S. economy's size in dollar terms. Investors were just as bullish; at the start of the decade j.a.pan's stock market was worth 50 percent more than that of the United States.

Persuasive though it was, the bullish case for j.a.pan, as fate would have it, turned out completely wrong. The next decade turned expectations upside down. j.a.pan's economic growth screeched to a halt, averaging just 1 percent from 1991 to 2000. Meanwhile, the United States shook off its early 1990s lethargy and its economy was booming by the decade's end. In 2000, j.a.pan's economy was only half as big as the U.S. economy. The Nikkei finished down 50 percent, while U.S. stocks rose more than 300 percent.

What explains j.a.pan's reversal of fortune and its decade-long economic malaise? Simply put, economic growth needs both healthy demand demand and and supply supply. As is well known, j.a.pan's deman demand for goods and services suffered when overinflated stocks and real estate collapsed, saddling companies and banks with bad debts that they had to work off. At the same time, though less well known, deep-seated forces chipped away at j.a.pan's ability to supply supply goods and services. goods and services.

The supply problem is critical because in the long run economic growth hinges on a country's productive potential, which in turn rests on three things: 1. Population2. Capital (i.e., investment)3. IdeasPopulation is the source of future workers. Because of a low birth rate, an aging population and virtually nonexistent immigration, j.a.pan's working-age population began shrinking in the 1990s. A smaller workforce limits how much an economy can produce.

Capital and ideas are essential for making those workers productive. In the decades after World War II, j.a.pan invested heavily in its human and economic capital. It educated its people and equipped them with cutting-edge technology adapted from the most advanced Western economies in an effort to catch up. By the 1990s, though, it had largely caught up. Once it had reached the frontier of technology, pushing that frontier outwards would mean letting old industries die so that capital and workers could move to new ones. j.a.pan's leaders resisted the bankruptcies and layoffs necessary for that to happen. As a result, the next wave of technological progress, based on the Internet, took root in the United States, whose economic lead over j.a.pan grew sharply over the course of the 1990s.

A Recipe for Economic Growth Numerous factors determine a country's success and whether its companies are good investments. Inflation and interest rates, consumer spending, and business confidence are important in the short run. In the long run, though, a country becomes rich or stagnates depending on whether it has the right mix of people, capital, and ideas. Get these fundamentals right, and the short-run gyrations seldom matter.

Until the eighteenth century, economic growth was so slight it was almost impossible to distin- guish the average Englishman's standard of living from his parents'.

.Between 1945 and 2007 the United States economy went through 10 recessions yet still grew enough to end up six times larger with the average American three times richer.

We've taken growth for granted for so long that we've forgotten that stagnation could ever be the norm. Yet, it once was. Until the eighteenth century, economic growth was so slight it was almost impossible to distinguish the average Englishman's standard of living from his parents'. Starting in the eighteenth century, this changed. The Industrial Revolution brought about a ma.s.sive reorganization of production in England in the mid-1700s and later in Western Europe and North America. Since then, steady growth-the kind that the average person notices-has been the norm. According to economic historian Angus Maddison, the average European was four times richer in 1952 than in 1820 and the average American was eight times richer.

In the pre-industrial era, China was the world's largest economy. Its modest standard of living was on a par with that of Europe and the United States. But China then stagnated under the pressure of rebellion, invasion, and a hidebound bureaucracy that was hostile to private enterprise. The average Chinese was poorer in 1952 than in 1820.

So why do some countries grow and some stagnate? In a nutsh.e.l.l, growth rests on two building blocks: population and productivity.1. Population Population determines how many workers a country will have. determines how many workers a country will have.2. Productivity, Productivity, or output per worker, determines how much each worker earns. or output per worker, determines how much each worker earns.

The total output a country can produce given its labor force and its productivity is called potential output, potential output, and the rate at which that capacity grows over time is and the rate at which that capacity grows over time is potential growth. potential growth. So if the labor force grows 1 percent a year and its productivity by 1.5 percent, then potential growth is 2.5 percent. Thus, an economy grows. So if the labor force grows 1 percent a year and its productivity by 1.5 percent, then potential growth is 2.5 percent. Thus, an economy grows.

Take a Growing Population Let's recap. An economy needs workers in order to grow. And, usually, the higher the population, the higher the number of potential workers. Population growth depends on a number of factors including the number of women of child-bearing age, the number of babies each woman has (the fertility rate), how long people live, and migration.

In poor countries, many children die young so mothers have more babies. As countries get richer and fewer children die, fertility rates drop and, eventually, so does population growth. As women have fewer children, more of them go to work. This demographic dividend demographic dividend delivers a one-time kick to economic growth. For example, it was a major contributor to East Asia's growth from the 1960s onward and to China's growth after the introduction of its one-child policy. But a country only gets to cash in its demographic dividend once. Eventually, as population growth slows, it ages and each worker must support a growing number of retirees. If fertility drops much below 2.1 babies per woman, the population will shrink unless it is offset by higher immigration. For this reason, a demographic cloud hangs over China. It may be "the first country to grow old before it grows rich," say population experts Richard Jackson and Neil Howe. Its fertility rate is below two and its working-age population will start to decline around 2015. delivers a one-time kick to economic growth. For example, it was a major contributor to East Asia's growth from the 1960s onward and to China's growth after the introduction of its one-child policy. But a country only gets to cash in its demographic dividend once. Eventually, as population growth slows, it ages and each worker must support a growing number of retirees. If fertility drops much below 2.1 babies per woman, the population will shrink unless it is offset by higher immigration. For this reason, a demographic cloud hangs over China. It may be "the first country to grow old before it grows rich," say population experts Richard Jackson and Neil Howe. Its fertility rate is below two and its working-age population will start to decline around 2015.

Add Capital A country is not rich, though, just because it has a lot of people-just look at Nigeria, which has 32 times as many people as Ireland but an economy of roughly equal size.

The reason for this population/economic size disparity is that the average Nigerian is much less productive than the average Irishman. For a country to be rich-that is, for its average citizen to enjoy a high standard of living-it must depend on productivity, which is the ability to make more, better stuff out of the capital, labor, and land it already has.

Productivity itself depends on two factors: capital and ideas.

You can raise productivity by equipping workers with more capital, which means investing in land, buildings, or equipment. Give a farmer more land and a bigger tractor or pave a highway to get his crops to market, and he'll grow more food at a lower cost. Capital is not free, though. A dollar invested for tomorrow is a dollar not available to spend on the pleasures of life today. Thus, investment requires saving. The more a society saves, whether it's corporations or households (governments could save but are more likely to do the opposite), the more capital it acc.u.mulates.

Capital, though, will only take a country so far. Just as your second cup of coffee will do less to wake you up than your first, each additional dollar invested provides a smaller boost to production. A farmer's second tractor will help his productivity far less than his first. This is the law of diminishing returns. law of diminishing returns.

Season with Ideas How do you overturn the law of diminishing returns? With ideas. In 1989, Greg LeMond put bars on the front of his bicycle that enabled him to ride in a more aerodynamic position. This simple idea sliced seconds off his time, allowing him to beat Laurent Fignon and win the Tour de France.

New ideas transform economic production the same way. By combining the capital and labor we already have in a different way, we can produce different or better products at a lower cost. "Economic growth springs from better recipes, not just from more cooking," says Paul Romer, a Stanford University economist. For example, DuPont's discovery of nylon in the 1930s transformed textile production. These man-made fibers could be spun at far higher speeds and required far fewer steps than cotton or wool. Combined with faster looms, textile productivity has soared, and clothes have gotten cheaper and better.

The productive power of ideas is nothing short of miraculous. Investing in more buildings and machines costs money. But a new idea, if it's not protected by patent or copyright, can be repro- duced endlessly for free.

.The productive power of ideas is nothing short of miraculous. Investing in more buildings and machines costs money. But a new idea, if it's not protected by patent or copyright, can be reproduced endlessly for free. Just as other cyclists quickly copied Greg LeMond's aerobars, companies catch up to their compet.i.tors by copying their ideas. Although this can be frustrating for the person who came up with the idea, it's great for the rest of us as we benefit from the improvements made with the existing idea. Here are a few examples: * New Business Processes. New Business Processes. Some of the most powerful ideas involve rearranging how a company runs itself. In 1776, in the first chapter of Some of the most powerful ideas involve rearranging how a company runs itself. In 1776, in the first chapter of The Wealth of Nations, The Wealth of Nations, Adam Smith marveled how an English factory divides pin making into 18 different tasks. Smith calculated that one worker, who could by himself make one pin a day, could now make 4,000. "The division of labor occasions, in every art, a proportionable increase in the productive powers of labor," he wrote. Two centuries later Wal-Mart revolutionized retailing by using big box stores, bar codes, wireless scanning guns, and exchanging electronic information with its suppliers to track and move goods more efficiently while scheduling cashiers better to reduce slack time. As compet.i.tors like Target and Sears copied Wal-Mart, customers of all three benefited from lower prices and more selection, a McKinsey study found. Adam Smith marveled how an English factory divides pin making into 18 different tasks. Smith calculated that one worker, who could by himself make one pin a day, could now make 4,000. "The division of labor occasions, in every art, a proportionable increase in the productive powers of labor," he wrote. Two centuries later Wal-Mart revolutionized retailing by using big box stores, bar codes, wireless scanning guns, and exchanging electronic information with its suppliers to track and move goods more efficiently while scheduling cashiers better to reduce slack time. As compet.i.tors like Target and Sears copied Wal-Mart, customers of all three benefited from lower prices and more selection, a McKinsey study found.* New Products. New Products. Netscape's Navigator was the first commercially successful browser but was soon supplanted by Microsoft's Internet Explorer, which is now under siege by Mozilla Firefox, Apple Safari, and Google Chrome. Browsers keep getting better but consumers still pay the same price, zero. Drugs provide another example. According to Robin Arnold of IMS Health, Eli Lilly's introduction of the antidepressant Prozac in 1986 inspired compet.i.tors to develop similar drugs like Zoloft and Celexa, providing alternatives for patients who didn't respond well to Prozac. Netscape's Navigator was the first commercially successful browser but was soon supplanted by Microsoft's Internet Explorer, which is now under siege by Mozilla Firefox, Apple Safari, and Google Chrome. Browsers keep getting better but consumers still pay the same price, zero. Drugs provide another example. According to Robin Arnold of IMS Health, Eli Lilly's introduction of the antidepressant Prozac in 1986 inspired compet.i.tors to develop similar drugs like Zoloft and Celexa, providing alternatives for patients who didn't respond well to Prozac.

It's not just companies that thrive by imitating their compet.i.tors. Entire countries can turbo-charge their development by strategically copying the ideas and technologies that other countries already use. For example, j.a.panese steelmakers didn't invent the basic oxygen furnace; they adapted it from a Swiss professor who had devised it in the 1940s. They thus leapfrogged U.S. steelmakers who were using less efficient open hearth furnaces. Their mainframe computer makers benefited from a government edict that IBM make its patents available as a condition of doing business there.

More recently, China's adaptation of existing ideas from other countries has resulted in significant economic growth. Since 1978, it has moved workers from unproductive farms and state-owned companies to more productive privately owned factories that used machinery bought or copied from foreign companies, expertise acquired from foreign universities or joint venture partners, and intellectual property adapted and occasionally stolen from foreign creators.

Still, once a country has copied all the ideas it can, future growth depends on waiting for new ideas or developing its own. Inevitably, a country at the technological frontier grows more slowly than one catching up to the frontier. As we learned earlier in this chapter, that's just what happened to j.a.pan.

Nurturing Growth Getting the ingredients right is essential to economic growth, but so is the environment that the government creates in order to foster its development. Like the temperature on the oven, the wrong setting can ruin the recipe. So, what do governments do that matters most?* Human Capital. Human Capital. It's no use equipping workers with the most advanced equipment in the world if they can't read the instructions. Education and training, both forms of human capital, are essential to productivity. Korea went from third world status to the ranks of the industrialized nations in a generation in part by rigorously educating all its children. Its high school graduation rates now exceed those of the United States. It's no use equipping workers with the most advanced equipment in the world if they can't read the instructions. Education and training, both forms of human capital, are essential to productivity. Korea went from third world status to the ranks of the industrialized nations in a generation in part by rigorously educating all its children. Its high school graduation rates now exceed those of the United States.* Rule of Law. Rule of Law. Economic growth needs investors to know that if they invest today, they get to keep the rewards years later. That requires transparent laws, impartial courts, and the right to property. The United States' army of lawyers sue at the drop of a hat and wrap every transaction in legalese, but in a maddening way that signifies its respect for laws. Economic growth needs investors to know that if they invest today, they get to keep the rewards years later. That requires transparent laws, impartial courts, and the right to property. The United States' army of lawyers sue at the drop of a hat and wrap every transaction in legalese, but in a maddening way that signifies its respect for laws.Small government is better than big government, but size is less important than quality. For example, Sweden's government spends more than half of gross domestic product (GDP) while Mexico's spends only a quarter of its GDP. But Swedish government is efficient and honest while Mexico's is inefficient and rife with corruption. That's one reason Sweden is rich and Mexico is poor.

Does government have to be democratic for growth? There's no firm rule. The authoritarian governments of China, Korea, and Chile ran smart policies that produced strong growth early in their development. Conversely, sometimes democratic governments are pressured by voters to expropriate private property, run up unsupportable debts, or shelter politically favored groups at everyone else's expense. But dictators have done all those things and worse, bringing on social unrest that ruins the investment climate. Democracy provides essential feedback to government just as free markets do to companies, and elections are generally less disruptive than civil wars.

* Letting Markets Work. Letting Markets Work. Entrepreneurs and workers get rich coming up with new, cheaper ways to make things. In the process, they drive someone else out of business. Joseph Schumpeter, the Austrian-born Harvard economist, called this "creative destruction." Governments squelch creative destruction by forbidding new companies from entering a market, granting monopolies, restricting imports or foreign investment, or making it hard for companies to lay off workers. A financial system that would rather lend to government-owned companies than small entrepreneurs also holds back growth. Entrepreneurs and workers get rich coming up with new, cheaper ways to make things. In the process, they drive someone else out of business. Joseph Schumpeter, the Austrian-born Harvard economist, called this "creative destruction." Governments squelch creative destruction by forbidding new companies from entering a market, granting monopolies, restricting imports or foreign investment, or making it hard for companies to lay off workers. A financial system that would rather lend to government-owned companies than small entrepreneurs also holds back growth.Into the Weeds Now that we've established what a country needs to grow, how do we measure that growth? The global gold standard is the GDP, which is the value of all the products and services a country produces in a year. GDP can be measured in two ways: 1. Expenditure-Based GDP. Expenditure-Based GDP. Total of all the money spent on stuff. Total of all the money spent on stuff.2. Income-Based GDP. Income-Based GDP. Total of all the money earned producing stuff. Total of all the money earned producing stuff.Expenditure-based GDP includes spending by consumers-on such items as houses, bread, and visits to the doctor-and by government-on such items as schools and soldiers. It also includes spending by businesses, but only on investment-related expenses-such as a bakery's new oven or building. GDP excludes business spending on inputs (e.g., ingredients and parts) that show up in what consumers buy. For example, a bakery's purchase of flour is included in what the consumer spends on bread. To add that to GDP would be counting it twice. Exports are also included in includes spending by consumers-on such items as houses, bread, and visits to the doctor-and by government-on such items as schools and soldiers. It also includes spending by businesses, but only on investment-related expenses-such as a bakery's new oven or building. GDP excludes business spending on inputs (e.g., ingredients and parts) that show up in what consumers buy. For example, a bakery's purchase of flour is included in what the consumer spends on bread. To add that to GDP would be counting it twice. Exports are also included in expenditure-based expenditure-based GDP because this represents what foreigners spend on things made in the United States. Imports are subtracted from GDP to exclude what Americans spend on things made in other countries. GDP because this represents what foreigners spend on things made in the United States. Imports are subtracted from GDP to exclude what Americans spend on things made in other countries.

Expenditure-based GDP is measured in nominal and real dollars. Nominal dollars Nominal dollars represent the actual value of activity. represent the actual value of activity. Real dollars Real dollars remove the effects of inflation. Suppose sales of bread rise 5 percent. If the price per loaf rose 2 percent, then real spending on bread (i.e., the number of loaves sold) rose 3 percent. That's real GDP and it's the usual way of measuring economic growth. However, you can't spend real GDP-wages and profits are earned in nominal dollars so nominal GDP is a better way to measure the size of the economy. remove the effects of inflation. Suppose sales of bread rise 5 percent. If the price per loaf rose 2 percent, then real spending on bread (i.e., the number of loaves sold) rose 3 percent. That's real GDP and it's the usual way of measuring economic growth. However, you can't spend real GDP-wages and profits are earned in nominal dollars so nominal GDP is a better way to measure the size of the economy.

The second method, income-based income-based GDP, includes the wages, benefits, and bonuses earned by workers and managers; the profits earned by companies and their shareholders; the interest earned by lenders; and the rent earned by landlords. GDP, includes the wages, benefits, and bonuses earned by workers and managers; the profits earned by companies and their shareholders; the interest earned by lenders; and the rent earned by landlords.

In theory, the expenditure-based GDP and income-based GDP sums should be equal, because one person's spending is another person's income. In practice, however, GDP is so large and difficult to measure with precision that it would be a miracle if calculating it two ways produced the same number.

When the U.S. Commerce Department's Bureau of Economic a.n.a.lysis calculates GDP, 75 percent of its initial estimate is based on surveys of actual activity like retail sales and construction. For the rest it gets creative. For example, it checks out the weather to estimate utility output or dog registrations to estimate spending at veterinarians' offices. It sounds goofy, but it lines up pretty well with the hard data that eventually replaces it.

Will the United States Become the Next j.a.pan?

As the United States struggles out of its eleventh, and worst, recession since World War II, a nagging worry hangs over it: Does it face a long period of stagnation as j.a.pan did in the 1990s? The pessimist could marshall a lot of evidence to answer yes. He'd contrast the technology bubble of the 1990s, which left the United States with broadband Internet and business-to-business web sites, with the real estate bubble of the late-2000s that did nothing for productivity and left behind trillions of dollars of bad property loans that are making it harder for the businesses of tomorrow to get money.

The pessimist would go on to note that Americans' faith in free markets has been shaken and government has grown. New regulators are cropping up and old ones are getting more intrusive. Finally, he'd point out that the labor force is growing more slowly and employment is no higher than a decade ago. Anti-immigrant sentiment could turn off the tap of young foreign workers while our schools, despite recent improvement, are global underperformers.

The optimist would reply that the United States still has the building blocks of growth. Its population growth and fertility rate remain among the highest in the industrial world and far higher than China's. Americans are jaded about finance but still like free enterprise. In April 2009, at the depths of the worst recession and bear market in memory, the Pew Research Center found that 90 percent of the people in this country said they admired people who get rich by working hard.

The optimist would go on to note that for all the rhetoric to the contrary, U.S. leaders still believe in free enterprise, as well. Within two years of taking stakes in nine major banks, the Treasury had sold all but one. True, the federal government propped up General Motors; but to get the money GM had to go through bankruptcy and shear off 30 percent of its U.S. workforce. By contrast, France gave money to Peugeot and Renault only after they promised to preserve French jobs.

Optimists would also point out that the United States' legal and democratic traditions have survived intact. Populist anger at bankers is at a fever pitch. Yet in the first major criminal trial stemming from the mortgage meltdown, jurors acquitted two traders for Bear Stearns, because, one said, "We just didn't have enough to convict them."

If the financial system can flush the bad debt left from the property bubble, then investment should resume and with it, productivity growth of perhaps 1.5 percent to 2 percent per year. Add that to labor force growth of 0.75 percent and you get long-term growth of 2.25 percent to 2.75 percent per year. The United States may no longer be a glamorous growth stock; but it's still a blue chip.

The Bottom Line * Long-term economic growth depends on population and productivity. A growing population is the source of future workers, and the more productive those workers are, the richer they become. It takes investment in both capital and ideas to raise productivity.* Ideas enable us to recombine the workers and the capital we already have in new ways to produce brand-new products or old products at a lower price. Compet.i.tion forces countries and companies to copy each other's ideas and constantly come up with new ones.* Both investment and ideas must be nurtured. Honest government and trustworthy laws encourage investors and innovators to take risks in hopes of reaping the rewards. Investment in education enables workers to take advantage of the latest ideas. And free markets ensure that dying, unproductive industries are culled so that growing industries can attract capital and workers.

Chapter Two.

Economic Bungee Jumping Business Cycles, Recessions, and Depressions . . . Oh My!

IN EARLY 1973 the New York Times New York Times asked four economists for their forecasts. Alan Greenspan predicted that the economy would grow 6 percent and declared, "It's very rare that you can be as unqualifiedly bullish as you can now." He was half right; the economy did grow 6 percent that year, but it was a lousy time to be bullish. A few days after the asked four economists for their forecasts. Alan Greenspan predicted that the economy would grow 6 percent and declared, "It's very rare that you can be as unqualifiedly bullish as you can now." He was half right; the economy did grow 6 percent that year, but it was a lousy time to be bullish. A few days after the Times Times article appeared, stocks entered a deep, multiyear bear market and by the end of the year the economy had fallen into its worst recession in decades. article appeared, stocks entered a deep, multiyear bear market and by the end of the year the economy had fallen into its worst recession in decades.

What happened? Economic growth and falling unemployment began to strain the economy's productive capacity. Inflation was rising and soon, so were interest rates. That October came the coup de grace: coup de grace: the Arab embargo sent oil prices skyrocketing. High interest rates and recession are a nasty combination for stocks and employment. the Arab embargo sent oil prices skyrocketing. High interest rates and recession are a nasty combination for stocks and employment.

Over long stretches, the economy grows thanks to our rising population and productivity. But in the short run, it goes through cycles of expansion and recession. Catching the bottom of the cycle can turbocharge your portfolio or business plan, while missing the peak can lay waste to both.