Understanding the Economy

By: Pedro Chacin, MBA

Anyone starting a financial plan, investment plan, or their own business needs an understanding of the economy and its cycles, and how they can be influenced by government policy. The economy is cyclical by nature; it has had periods of growth and periods of stagnation. Historically in the US every 9 to 11 years, after a period of growth comes a recession, a time where the growth halts, or even reverses, usually 2 or more quarters. Understanding what causes recessions, how it can be confronted, and its consequences is paramount to be able to make better financial decisions.

The health of the economy has been traditionally measured by 5 important indicators: Gross Domestic Product Growth (GDP Growth), Money Supply (M2), Unemployment rate, Consumer Spending, and Inflation. There are many other indicators that help understand past, current and future behavior of the economy such as such as the financial market indicators (i.e., S&P 500, Nasdaq, and the Dow Jones Industrial Average), while government bond yields (i.e., the yield curve) can predict recessions, economic expansions, and a few other predictors.

Changes in these indicators allow us to understand what has happened, what is happening, and what will happen in the economy. For instance, two consecutive quarters of negative GDP growth marks the official occurrence of a recession. The GDP measures the dollar amount of goods and services produced by the economy in a particular time frame, or the size of the economy. For a country to improve its standard of leaving its GDP must grow at a faster pace than its population so that its GDP per capita increases.

Recessions can be caused by internal or external factors. Among internal factors are lack of consumer confidence, real estate or financial bubbles, credit crisis, and erroneous fiscal or monetary policies. Some of the external factors could be wars, energy (oil mainly so far) crisis, terrorism, and Black Swan events like a pandemic. Consequences of recessions are unemployment, decreased demand, deflation, increased debt, credit tightening, fear and uncertainty.

In market economies governments influence the economy by using Fiscal and Monetary policies to maintain a healthy growth or to rescue it from recessions. In normal times governments regulate interest rates (monetary policy) to control the amount of money in the economy and to keep inflation under control and modify tax rates (fiscal policy) to increase or slow down growth. During recessionary periods governments become more aggressive, putting a wide range of tools into action generally using specifically designed programs to that effect.

The XXI Century has already seen two of the worst crises ever experienced and the swift response of the US government should be reviewed. Crises repeat and learning about them will prepare us for the future.

During the 2007-2009 financial crisis, also known as the Great Recession, the US government enacted the Troubled Asset Relief Program of 2008 (TARP) ($700 billion) to help stabilize the U.S. financial system, restart economic growth, and prevent avoidable foreclosures, keeping families in their homes. This program specifically targeted the auto industry, the credit market, the banking system, and the saving of AIG. In 2009, the government approved the American Recovery and Reinvestment Act of 2009 (ARRA) ($800 billion) to stimulate job creation by cutting taxes and investing hundreds of billions of dollars over two years in critical sectors such as energy, health care, infrastructure, and education. It also enacted the Unemployment Insurance Reauthorization, and Job Creation Act of 2010 ($56 billion) which provided tax relief and investments in the workforce to create jobs and accelerate economic growth targeting support for working families, extending key provisions of ARRA including the Earned Income Tax Credit (EITC) and the Child Tax Credit (CTC), cutting the payroll tax, and continuing extended unemployment insurance benefits.

More recently during the 2020-2021 COVID-19 pandemic, which caused damage unlike anything in modern time, the US government responded by enacting a few laws. The Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020 ($1.7 trillion) provided assistance for American workers and families, small businesses, state, local and tribal governments, renters, and big transportation and services companies. The American Rescue Plan Act of 2021 ($1.9 trillion) provided funding for agriculture and nutrition programs, schools and institutions of higher education, COVID-19 vaccinations, renters and homeowners, state, local, tribal, and territorial governments, small businesses, health care, transportation and federal employees; it extended unemployment benefits, provided a recovery rebate of $1,400 per eligible individual, expanded certain tax credits, and provided premium assistance for health insurance coverage, among others. Monetary policy implemented by the Federal Open Market Committee (FOMC) included the drastic lowering of interest rates, increased holding of treasury and mortgage backed securities to ensure the credit flow, increasing purchase of corporate debt ($750 billion set aside) and injecting much needed cash to public companies that stabilized the financial markets. More than $1 trillion was set to invest by the Fed into the financial system.

The actions of the US government to stabilize the economy, by helping the people, and the businesses as well as the financial markets, which was necessary though in the long run it will have long term consequences. This extraordinary amount of money is coming from debt that must be paid through higher taxes mostly. Also, the injection of money into the economy will more likely bring higher inflation, especially in periods in which the supply chain may be disrupted like in this case.

Lastly, it is important to understand how economic policy is affected by politics and government actions. The U. S. Democratic party favors equal economic opportunity, a social safety net, strong labor unions, a mixed economy and a progressive tax system, higher minimum wages, universal health care, public education, and subsidized housing. The Republican party supports individual freedom, lower taxes, free-market capitalism, less government intervention, increased military spending, deregulation, restrictions on labor unions, and support for school choice. However, economic growth is not only affected by social political reasons, but by other components such as the availability of physical, human, and technological capital and labor productivity.

Knowing that our finances is affected by so many economic situations, therefore an understanding of the economy and how politics might influence is a must for every person. Acquiring a minimum of financial and economic education is a requirement to improve the chances of success in business or in everyday life.

Pedro Chacin is an engineer (University of Michigan) with a Master of Business Administration (MBA) from Texas A&M University; he has more than 38 years of professional experience, the first 23 years in the oil and technology sectors, the last 15 years in the financial services sector, and for 12 years as a university professor of Economics and Finance.

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