CHAPTER ONE

The ECONOMY
and YOU

ALMOST TWENTY YEARS AGO, WHEN he was running for president for the first time, Bill Clinton had a campaign strategist from Louisiana named James Carville. Carville, whose nickname was the Ragin’ Cajun, gets a lot of credit for Clinton’s victory because he focused the campaign on the economy. He even wrote the words “It’s the economy, stupid” on a piece of paper and posted it in the campaign’s war room, a sort of mission control, so that no one would forget what they should be emphasizing.

What did Carville mean? He understood that the early 1990s, much like the last few years, and of course the Great Depression, were a time of financial worry for many people. When the economy is chugging along nicely, there are plenty of jobs, businesses are growing, and prices on things that you need to buy every day, like gas and milk, aren’t out of control, and as a result most people feel safe and secure. When it is not, people want change—and they vote for change. That’s what ushered Barack Obama into the White House in 2008. By making sure that the Clinton team remembered, every day, that the economy was issue number one, Carville and company won the White House.

The economy has been issue number one in the last few years as well. Any time you turn on one of the twenty-four-hour news channels, you are likely to hear about it. But what is the economy? What is it really?

The economy, simply put, is the exchange of goods, services, and natural resources by people and companies. Goods are physical products. Guitar Hero is a product. So are AirHeads. Services are jobs or functions that people or companies perform for one another. Cooking dinner in a restaurant is a service, so is designing a website or fixing an air conditioner. And natural resources are non-man-made items that can also be exchanged. Coffee, natural gas, and water are all natural resources. When people talk about “the economy” on television, they are usually talking about the national economy of the United States. But your town, city, state, and region have smaller economies of their own. And the global economy includes all of the different goods and services being exchanged around the world.

I Asked: How is the economy doing?
You Answered:

As you can see, when I asked the question, the perception was that the economy was struggling. But there is—at any point in time—a real way to tell how the U.S. economy is doing. We have many ways to measure it, but the main measurement tool is called GDP, or gross domestic product. This is the value of all of the goods and services in the country. Essentially, it’s the size of the economy, but you won’t usually see GDP expressed as a dollar amount. Instead it’s expressed as apercentage and used as a comparison from quarter to quarter or from year to year. For example, you might hear a reporter on a financial news station report that the U.S. GDP is up 2 percent year-over-year. That means the economy is 2 percent larger than it was last year. If GDP is up, the economy is growing, and that means good things, like more goods, more services, and more jobs.

GDP tells us what is happening in real time. Then there’s the crystal-ball data—signals, or indicators, that tell economists if things are headed up or headed down. Some of these signals are called leading indicators. They move ahead of the economy. If a leading indicator is up, the economy as a whole will likely be growing. The stock market is a leading indicator. It goes up before the economy does. Other signals are lagging indicators; they move after the economy. Unemployment is a lagging indicator. It improves after the economy is already showing signs of getting better.

And then there is inflation. Inflation is a measure of the price increase in goods and services. You may think higher prices are always a bad thing, but they’re not. If an economy is going to continue to grow, prices have to go up and wages need to rise. The key is that neither of those things goes up much more quickly than the other. For example, if prices rise too far too fast, but the amount of money you’re earning lags behind, you likely won’t have enough money to buy the things you need. And if you—and all the consumers like you—aren’t spending, the economy will suffer as a result. Back in the 1970s the United States went through a period of double-digit inflation. The economy was struggling, the Vietnam War had just ended and energy prices were soaring (ask your parents to tell you about the lines at the gas pumps when Jimmy Carter was president and they were kids). Since then things have been much better. Recently, inflation has been averaging about 3 percent, which has no one worried.

Look at a Dollar Bill

On the front, in the top left corner, right under “THE UNITED STATES OF AMERICA,” it says in smaller type: “This note is legal tender for all debts, public and private.” You’ll find the same words on every bill, from twenties to hundreds, and they mean that the U.S. government will back up a dollar with a dollar. And because the government always has, everyone therefore believes a dollar is worth a dollar.

The next question, of course, is: What’s a dollar worth? Your parents may chuckle and say something like, “Not as much as it used to be.” That’s because of inflation, which over time has eaten away at the purchasing power of the dollar. When I was your age, for example, I could buy a can of Mountain Dew (my favorite!) for twenty-five cents in the vending machine at my summer camp. Today the same can of Mountain Dew is likely to cost you seventy-five cents or even a dollar. That’s inflation at work.

You Wanted to Know:

It actually affects the U.S. economy a great deal. For the last few decades 70 percent of our economy has been totally supported by consumer spending—on everything from food and housing to health care to stuff. The other 30 percent of GDP comes from government spending. Over the past few years your parents and other adults started saving more and spending less, which was good for them individually, but it wasn’t all that good for the economy as a whole. Spending money rather than socking it away boosts the fortunes of companies and the economy overall.

We also get a sense of how the economy is doing by looking at these indicators:

CONSUMER CONFIDENCE: This is how positive consumers are feeling about how the economy is doing. It is measured by how much people are saving and spending.

THE DEFICIT: If you spend more money than you have, you have a debt. The amount of that debt is the amount you owe. When the federal government spends more than it takes in—from taxes and other sources—each year, that is called a deficit. If the government is able to spend only what it takes in, then its budget is balanced. One worry of a big deficit is that it can lead to inflation.

You Wanted to Know:

I wish it were as easy as that. Unfortunately, though, if you make more money without increasing the value of what’s backing up that money, its value will drop.

You’re probably wondering, What backs up our money? The answer is the strength of our economy and the amount of goods and services that we produce. If our economy gets bigger, our money will get stronger and remain strong. If we just print more money or pump more into the system, its value will drop. Inflation, or an increase in the prices of goods and services, would also occur.

UNEMPLOYMENT AND THE UNEMPLOYMENT RATE: This is another indicator of how the economy is doing. If you’re over the age of sixteen and have a job or are actively looking for a job, you are a part of our nation’s labor force. If you are in the labor force and you don’t have a job, you are unemployed. Every month the government conducts a survey to get an idea of how many people are working and how many people are unemployed. In July of 1999, 4.3 percent of the nation’s labor force was unemployed. That’s about where the unemployment rate should be. At that point few people are worried about it. Ten years later, in early 2010, the unemployment rate soared to 9.7 percent and many people were worried because it was yet another signal that the economy was suffering. When the unemployment rate is high, people have less money, they buy less, and fewer goods are produced.

You Wanted to Know:

In recent years more banks have failed than usual. In 2009, 92 banks failed, the largest number since 1992, when 181 banks failed. Your money is safe, though, because of something called the Federal Deposit Insurance Corporation, or FDIC. The FDIC was established by the Banking Act of 1933. The FDIC was created after the Depression to restore people’s confidence in banks. Until 2008, any individual account holder could put up to $100,000 in a bank and know that it was insured by the government. If the bank went under, the government would be responsible for giving you back your money up to that $100,000 amount. In 2008, however, we entered the period called the Great Recession.

A recession is defined as a period of economic decline of usually two quarters or more. Technically, economic growth— as measured by GDP, the value of all reported goods and services produced by the United States—falls over that half year. And during that time, typically, unemployment is rising, personal income is falling, people are buying less stuff, and the stock market is headed down. A depression is longer than a recession, and unemployment hits double digits, meaning that 10 percent or more of adults who are looking for work can’t find it. Here’s a joke from when I was a kid:

Not so funny, I know. During the Great Recession jobs were being lost. Banks and brokerage houses were going under. And the head of the FDIC, a woman named Sheila Bair, started to fear that we were going to have another period of panic and bank runs, and that that would make an already shaky economy even worse. So she worked to have the limits on FDIC insurance raised. Today, as a result, each individual can put up to $250,000 into any one bank and know that it is insured by the FDIC. What if you have more money than that? Then you need two names on the account—a husband and a wife, or a parent and a child—to double the protection. Or you need to open accounts at two or more different banks.

One more thing: Just because a bank fails does not mean you have to rush to pull your money out. Typically, a bank fails when it can’t meet the needs of its depositors. Then the FDIC steps in. It may operate the bank itself as a federally owned bank or very quickly sell the bank to another bank that isn’t having financial problems. Unless you read about it in the paper or online, you as a depositor may not even know what’s happening. You can still use your debit card or write checks. You can still use your ATM card. You just may go to sleep thinking that your money is in the First National Bank and wake up to find that it’s in the Second National Bank. Eventually you’ll get a new ATM card or debit card or checks, but there’s no need to panic, because you’re not likely even to feel the change.

INTEREST RATES: And here is another economic indicator. Everything has a price… even money. Interest rates are the prices that people pay to borrow money, generally from a bank, a company, or another person. They are also the prices you might receive for loaning your money out. If you have a savings accountat a bank, you are getting paidinterest. Why? Because when you deposit money in the bank, you are allowing the bank to use your money to make loans. In return for that, the bank pays you interest. For example, say you put $100 in the bank and your bank pays you 3 percent interest every year. At the end of one year you’d have an extra $3 and change. (The change comes from something called compounding—an incredible way to make whatever money you have today into more money tomorrow. We’ll talk more about it later in the book.)

But what determines interest rates? Let’s focus on one interest rate in particular. The fed funds rate is the interest rate at which the Federal Reserve (the central bank of the U.S. government) lends money to banks. It is controlled by the Federal Reserve itself. Eight times a year the Federal’s Open Market Committee meets to decide whether it will raise the federal funds rate, lower it, or leave it unchanged. Many other interest rates—from the prime rate (the interest rate that banks charge their best customers), to the interest rate you earn from your bank on your savings, to the interest rates you pay to buy a house or a car—are affected by changes in the fed funds rate. But interest rates aren’t the only things affected. The stock market tends to rally, or move higher, when interest rates are reduced, because businesses can borrow more money cheaply. When interest rates rise, the stock market generally has the opposite reaction.

The Federal Reserve’s Chairman and its Board of Governors understand that if interest rates are high, people are likely to borrow (and spend) less and save more. And if rates are low, people are likely to borrow (and spend) more and save less. They use this knowledge to move the economy to a place where it is growing not too quickly, not too slowly, but just right. (This is called the Goldilocks economy.) Getting the economy to behave like the fairy tale, however, is far from easy. It takes a lot of understanding of how the economy works, and sometimes trial and error. And it’s not a perfect science. Think of it this way: The Fed has tools that can help the economy along, but it can’t control it completely.

Understanding the
Federal Reserve

Managing the nation’s money is a big job… but it must be done. In the United States that job falls to the Federal Reserve. The Federal Reserve—or the Fed, as it’s commonly known—is our nation’s central bank.

Created in 1913, the Federal Reserve System was designed to keep our country’s monetary and financial system safe and stable. The Federal Reserve is made up of twelve banks across the country and a number of branches. These banks and branches are under the careful watch of a group known as the Board of Governors. The board is made up of seven members who are first chosen by the president and then approved by the Senate. The Fed regulates the United States’ interest rates and money supplies; distributes money to the country’s banks, credit unions, and savings and loans associations; provides financial services to the U.S. government; and educates the public about the economy.

Since 2006 the Federal Reserve chairman has been Ben Bernanke—Time magazine’s Person of the Year in 2009 for avoiding another Great Depression. Before becoming chairman, Bernanke was the chairman for the president’s Council of Economic Advisers. He also served in several other roles in the Federal Reserve System and for many years was an economics professor. How did Bernanke get so smart about the economy? He studied. A lot. Bernanke graduated from Harvard with a degree in economics and went on to get his PhD in the subject from the Massachusetts Institute of Technology. Time called him “the most powerful nerd on the planet.” Sometimes being a nerd pays off big-time.

© 2010 Jean Chatzky

---

Excerpted from Not Your Parents' Money Book: Making, Saving, and Spending Your Own Money by Jean Chatzky
All rights reserved by the original copyright owners. Excerpts are provided for display purposes only and may not be reproduced, reprinted or distributed without the written permission of the publisher.