Classical Economics Series: #1 Intro & Economic Growth

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This economic series is meant to be educational. It will cover: Economic Growth, The Business Cycle, Supply, Demand, Prices, Inflation, Unemployment, Imports, and Exports. It is mostly academic so it will have a school-vibe, but without the homework or tests! Unlike school though, the tests we face are real-world tests such as pursuing our own financial improvements to reach financial freedom. It will not include much of my own opinion or analysis because that is not the goal for this series. The goal for this series is for you to understand the economics of a nation (macroeconomics), so you can use that understanding to become good investors!

Economics is the study of how society uses resources for the development, production, procurement, distribution, and consumption of tangible products (iPhones) and intangible services (Apple Music).

The most important name in today’s economic system is John Maynard Keynes. Come back later for more articles about economists across the ages, such as The Austrian School of economics (also significant!). But, Keynes is the one who developed economics as we know it. He wrote “The General Theory of Employment Interest and Money” in 1936 in the UK. Similar to Copernicus seeking to understand the movement of the Sun, planets, and stars, Keynes wanted to understand unemployment because The Great Depression was full of it and existing understanding of economics did not explain what happened well.

Keynes wanted to understand what existing economics could not explain about The Great Depression – but he did so with an emphasis on unemployment and by taking snapshots of the economy, as if it was static. So what he developed is useful, but lacks usefulness on growth or inflation issues.

For instance, Keynes wanted to understand how employment and prices affect each other; how government affected employment and prices; and more than anything, he wanted to know how to “control” or at least influence economies/money, such as how to drive employment up. More or less, Keynes used existing approaches that microeconomists used when evaluating businesses, plus some new approaches to expand economic knowledge into something bigger: macroeconomics. Simply put, Keynes took what was small/local and made it big – big enough for governments to use! Naturally, macroeconomics includes microeconomics since the economy of each piece would be part of the economy of the whole machine.

Later came Milton Friedman who pointed out that Keynesian Economics could not explain the relationship between price levels and economic output. He called this “the missing equation.”

Friedman melded classical economics understandings of Adam Smith and others who came before Keynes with Keynesian Economics. Friedman concluded that the classic theories worked in the long-run, but Keynesian Economics works in short intervals.

So it is like “What goes up must come down” being right locally (or in your back yard), but on a bigger scale it is wrong (the meteorites from Mars that have landed on Earth did not come back down to Mars when they went up).

Building on Friedman’s question, an economist from New Zealand began working with 100 years of UK data on the relationship between unemployment and inflation. The economist’s name was AW Phillips, and his work became known as The Phillips Curve. This curve was adopted by economists worldwide and is a major contributor to economics. It shows that as Unemployment rose, wages fall, and when Unemployment falls, wages drop.

Friedman and fellow economist Edmund Phelps felt that manipulating monetary policy (managing inflation) was not the right way to manage Unemployment and that Unemployment should be left “natural” and unaltered by central banks.

Then in the 1970s and 1980s the US experienced both high Unemployment and high inflation. Phelps and Friedman then clarified the understanding to show that The Phillips Curve was true if inflation was unanticipated. If it was anticipated, then the conditions were different. This ushered in a whole new element to economics: Expectations are part of the equation in a significant way.

Nowadays, we see expectations set by world governments very deliberately so they can use that as yet another way to manage economic systems. “A period of somewhat-higher inflation can be expected in the next two quarters,” is common to hear from a Fed Chairman since this economic understanding came to be.

Of note, since the late 80s/early 90s, economic growth theory has dominated economist efforts, as inflation, employment, and prices were already being managed and GDP expansion continued as a top priority.

Let’s not forget how the interest and need for macroeconomics got started: The Great Depression. The Great Depression was not just in the US. It was global. It started in the US though in 1929, and by 1930 had reached the UK. Half of Britain’s trade (sales around the world) disappeared, and in some areas unemployment reached 70%! No wonder efforts were made to understand economics better! The US had an awful time through The Great Depression too of course, as did countless other countries! For the US, The Great Depression did not end until we entered WWII in 1941. The statistics and the stories are really sad, and to this day people and governments study, fear, and work to avoid the things that led to The Great Depression. The Industrial Revolution followed by The Great Depression followed by WWII followed by The Cold War firmly cemented Keynesian Economics into world governments.

Understanding what causes those economic booms (a hot economy) and busts (a cold economy) is business cycles. You may think that you always want your economy hot, but that is actually not true. Booms can lead to bubbles and bubbles pop and you get busts. More on that later though. Understanding business cycles is one piece of the economy. But another piece of the economy is understanding growth.

As investors, if we understand where things have been we can better understand where things are going — and that’s a major strategic advantage.

When you add up all of the goods (iPhones) and services (Apple Music) you get GDP (Gross Domestic Product, or in other words Total County Production measured in dollars). GDP has been growing for 200 years for capitalist countries. (Note: there is no purely capitalist country, but each country has rules and people that are more capitalistic than others.)

GDP across decades has a very obvious upward trend, but GDP throughout the weeks, months, quarters, and a year however have significant ups and downs. It is within these ups and downs that successful investors live and profit.

The last concept to introduce in this article is inflation. For most people the word has nothing but negative connotations. But in the world of Keynesian economics the word inflation is a given and it is managed with government actions. Simply put: inflation is a rise in prices. Most people think inflation is simply a devaluing of currency, but consider this: if currency was devalued then prices would go up, no? They would. So devaluing currency is a type/cause of inflation… and there are other types/causes too.

When prices go up enormous amounts this is called hyperinflation. For instance, between WWI and WWII Germany had inflation of 230% per month at times! That means every day prices went up 4%! So if milk cost $1 on Monday, it cost $1.04 on Tuesday, $1.08 on Wednesday, $1.12 on Thursday, and $1.17 on Friday. By the end of the month milk would cost $2.30. By the end of the year milk would cost $8.20! And a $25,000 car would cost $180,020.60 if those inflation rates happened to us today! No wonder it scares people! 

Historically, the US has managed inflation well. Our worst experience was in the 1970s when inflation reached 7% from 1973-1975. We used many tools and expert decision-makers to keep it down and return to the 4% average we have had since 1946 (on the heels of WWII). Before WWII, the US averaged about 1.7% inflation.

Around the world though, countries have been far more adversely affected by inflation. As mentioned, Germany experienced 230% inflation per year. Israel saw 400% inflation in 1985; Argentina has seen 700% inflation; Bolivia saw 12,500% in 1984. There are many more examples, but Keynesian economics does indeed have an understanding, tools, and systems that manage inflation well.

Inflation is like cancer to economies — and it must be detected early and expertly managed. When inflation is detected, it gets everyone’s attention!

So that’s the introduction to economics! There is a lot more to follow, but I hope you liked what you read and have learned something too! Is this enough understanding for you to go start investing in stocks with great success? No. But we will build to that.

The key concepts in this article to remember are:

John Maynard Keynes thinking about all this…
20th century macroeconomics being the result of that thinking…
Government using macroeconomics to influence and manage a country’s resources/money/economy…
Milton Friedman identified the relationship between prices and economic output…
AW Phillips identified the relationship between Unemployment and inflation, known as The Phillips Curve…
Phelps-Friedman established Expectations as a key component of an economy…
Business cycles, GDP, and inflation as the major factors government considers…
Since the late 80s/90s, economic growth has become the priority for economists.

Al Capone’s soup kitchen in 1930 / Getty Images via Insider.com

This series uses resources such as Investopedia.com, Wikipedia.com, and my college textbook “Macroeconomics”, 2nd edition, Roger EA Farmer that came with a free CD inside! Now that ages me. But the fact that the textbook is old shows two important things: 1. I have loved all things economics, business, finance, and investing for decades! 2. The study of economics does evolve but what is classic is still powerful and important to understand, and knowing where things have been, and currently are, helps you project where they will be! A priceless skill to hone for investors! I mean, countless people were very sure electric vehicles such as Tesla $TSLA made no sense investment-wise. Maybe they should have opened up their mind to include more economic material! So here’s some classic foundational material for you, and from there we can begin to see changes, directions, and opportunities!

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