I ou O fam UJ t g , gu age u eoerY t • l yo sts tel e econo ttt hOu, 9· , rt i o g r e i t 's ' '1l / Economics ExfJlained Roberl L Heilbroner and Lester C Thurow Prentice-Hall, Inc., Englewood Cliffs, New Jersey 07632 Book Design by Joan Ann Jacobus Art Director: Hal Siegel Economics Explained by Robert L Heilbroner and Lester C Thurow © 1982 by Robert L Heilbroner and Lester C Thurow The boxed material in this book and the Appendix on banking are taken directly from Robert L Heilbroner and Lester C Thurow, The Economic Problem, 6th ed., Prentice­ Hall, 1980 All rights reserved No part of this book may be reproduced in any form or by any means, except for the inclusion of brief quotations in a review, without permission in writing from the publisher Address inquires to Prentice-Hall, Inc., Englewood Cliffs, N.J 07632 Printed in the United States of America Prentice-Hall International, Inc., London/Prentice-Hall of Australia, Pty Ltd., Sydney/Prentice-Hall of Canada, Ltd., Toronto/Prentice-Hall of India Private Ltd., New Delhi/Prentice-Hall of Japan, Inc., Tokyo/Prentice-Hall of Southeast Asia PteLtd., Singapore/Whitehall Books Limited, Wellington, New Zealand 10 Library of Congress Cataloging in Publication Data Heilbroner, Robert L Economics explained Includes index Economics I Thurow, Lester C II Title 81-20975 330 HB171.H479 AACR2 ISBN0-13-229708-6 ISBN0-13-229690-X {PBK} • Contents Introduction v I The Economic Background One Capitalism: Where Do We Come From? Two Three Great Economists 17 Three A Bird's-Eye View of the Economy 34 Four The Trend of Things 45 II Macroeconomics-The Analysis of Prosperity and Recession Five The GNP 63 Six Saving and Investing 71 Seven Passive Consumption, Active Investment 80 Eight The Economics of the Public Sector 89 Nine The Debate About Government 99 Ten What Money Is 108 Eleven How Money Works 116 Twelve The Inflation Problem: I 124 Thirteen The Inflation Problem: II 132 Fourteen Falling Behind: The Productivity Problem 145 Ill Microeconomics-The Anatomy of the Market System Fifteen How Markets Work 157 Sixteen Where Markets Fail 168 Seventeen A Look at Big Business 179 Eighteen The Distribution of Income 190 IV The Rest of the World Nineteen Defending the Dollar 205 Twenty The Multinational Corporation 220 Twenty-one Where Are We Headed? 230 Appendix: How the Banking System Works 241 Index 250 • Introduction Books on economics abound Most of them have two pur­ poses They tell you how to make a great deal of money-in the stock market, in real estate, in gold; or they tout some kind of economic salvation-less government or more government, less regulation or more regulation, less capitalism, more capitalism There is one overwhelming problem with both kinds of books They don't work The books about money not make you money-if they did, the United States would be crawling with millionaires And the books about economic salvation not set your mind at ease They just make you feel better for a moment Then why people go on buying these books? At bottom, we believe it is because they are in search of something more serious than instant riches or saving the world They want to understand the nature of the economic forces that are upsetting their lives They want to know the meaning of the incomprehensible vocabulafy they read every morning in the newspapers and hear every night on TV-the "money supply'' and "gross national product" and "government deficits" that are somehow connected with their personal and public woes and misfortunes Is it not the truth that we simply not understand the very words that are supposed to tell us what is the matter? That explains the purpose of this book To say it as directly as possible, we have written a book based on our conviction that a great many people seriously want to know what economics is all about Thereafter, if they still want advice on getting rich, or a tract for our times, fine At least they will then understand the words the author is using Our belief in an audience that wants to learn about econom­ ics comes from personal experience We are the authors of a college text that has gone through many editions.* But increasingly it has dawned on us that the people who are most eager to understand economics are not students who want to pass a course, but men and women in the real world who need to make their way intelligently * Robert L Heilbroner and Lester C Thurow, The Economic Problem, 6th ed., Prentice-Hall, 1980 V vi Introduction through life This is the economics they ought to know-not to get rich, and not to have a particular point of view, but simply to be effective investors, educated business persons, informed workers, or just good citizens Now a word about the book itself It is, of course, meant to be read straight through, and it will present a coherent story about economics if you so But it is also designed to fit different needs Someone who wants to know about international economics, for instance can turn to Part IV Readers who can't wait to find out what we have to say about inflation can begin with Chapter Twelve Needless to say, later chapters will mean more if you have read the earlier ones, but the book can be used selectively-skipped over, dipped into, read from back to front if you want Economics Explained is very different from the text from which it derived its original inspiration But two resemblances remain we hope First, it is a book of teaching, not preaching There are plenty of controversial opinions in the book, but they are always labeled as such, never slipped across as The Truth Second, the test of a textbook is whether a student sells it back to the college bookstore at the end of the year or keeps it around because, who knows, it's the kind of book he or she might want to look into again someday We would like this to be that kind of book for you Robert Heilbroner Lester Thurow • THE ECONOMIC BACKGROUND One Capitalism: Where Do ffi? Come From? We live in a capitalist economic system Politicians constant­ ly talk about capitalism, or if they don't like the word, about the free-enterprise system We are aware that the world is divided between capitalist and noncapitalist systems; and we are constantly being told that capitalism is the wave of the future, or would be the wave of the future if only it were left alone, or that capitalism is in decline and will fall of its own weight, like the Roman Empire Perhaps there is no more important economic question than the future of capitalism, none that affects more deeply our private destinies and those of our children As we will see in our next chapter, the great economists of the past were vitally concerned with this issue Modem economists are wiser or blinder, depending on how you look at it, and say relatively little about our long-term prospects Nonetheless, we feel that it is impossible to understand capitalism without at least some understanding of its roots So we are going to begin the study of our economic system rather the way a doctor begins to become acquainted with a patient-by taking its history Many people speak about capitalism as if it were as old as the hills, as ancient as the Bible, implying that there is something about the system that accords with human nature Yet, on reflection, this is clearly not the case Nobody ever called the Egyptian pharaohs capitalists The Greeks about whom Homer wrote did not comprise a business society, even though there were merchants and traders in Greece Medieval Europe was certainly not capitalist Nor would anyone have used the word to describe the brilliant civiliza­ tions of India and China about which Marco Polo wrote, or the great empires of ancient Africa, or the Islamic societies of which we catch glimpses in The Arabian Nights What made these societies noncapitalist was not anything The Economic Background they possessed in common, for they were as different as civilizations could be, but rather, some things they lacked in common To become aware of these lacks will give us a sharp sense of the uniqueness and special characteristics of capitalism itself To begin with, all these noncapitalist societies lacked the institution of private property Of course, all of them recognized the right of some individuals to own wealth, often vast wealth But none of them legally accorded the right of ownership to all persons Land, for instance, was rarely owned by the peasants who worked it Slaves, who were a common feature of most precapitalist systems, were only rarely permitted to own property-indeed, they were property The idea that a person's property was inviolate was as unacknowledged as that his person was inviolate The Tudor monarchs, for example, relatively enlightened as sixteenth-century monarchies went, could and did strip many a person or religious order of their possessions Second, none of these variegated societies possessed a central attribute of capitalism-a market system To be sure, all of them had markets where spices, gold, slaves, cloth, pottery, and foodstuffs were offered for sale But when we look over the expanses of ancient Asia, Africa, or the Egyptian and Roman empires, we can see nothing like the great web of transactions that binds our own economy together Most production and most distribution took place by following the dictates of tradition or the orders of a lord In general, only the small leftovers found their way to the market stalls Even more important, there was no organized market at all to buy and sell land, or to hire labor, or to lend money Markets were the ornaments of society, tradition and command its iron structure Under such conditions, the idea of economic freedom was held in little regard When peasants were not free to move as they wished, when artisans were bound to their trades for life, when the relations of field-workers to their masters were that of serf to lord, who could worry about the right of contract or the right to withhold one's labor? T he distinction is crucial in separating capitalism from what came before: a capitalist employee has the legal right to work or not work as he or she chooses; and whereas this right may seem to count for little under conditions of Dickensian poverty, it must be compared with the near-slavery of the serf legally bound to his lord's land and to the work his lord assigns him In such a setting, moneymaking itself was not much es­ teemed Ambitious persons from the better walks of life sought • Capitalism: Where Do We Come From? fame and fortune in military exploits, in the service of the court, or in the hierarchies of religion In this regard, it is interesting to reflect how twisted and grasping are the faces of merchants depicted by medieval artists, in contrast to the noble mien of soldiers and courtiers Moneymaking was generally considered to be beneath a person of noble blood; indeed, in Christendom it was a pursuit uncomfortably close to sin Usury-lending at interest-was a sin-in fact, a mortal sin As a consequence of all this, society's wealth was not owned by "the rich"-that is, by those whose main efforts were directly aimed at moneymaking-but rather by the powerful, who seized it in the struggle for lands and privileges Of course, the winners in this struggle became rich, sometimes unimaginably rich, but their riches flowed from their power, not the other way around Julius Caesar, for example, only became rich because he was appointed governor of Spain, from which he profited fabulously, as all provin­ cial governors were supposed to and did Last, and in some ways most significant, economic life was stable It may not have seemed so to the peasants and merchants whose lives were constantly disrupted by war, famine, merciless taxation, and brigandage But it was very stable compared to the tenor of economic life in our own time The basic rhythms and techniques of economic existence were steady and repetitive Men and women sowed and reaped, potters and metalworkers turned and hammered, weavers spun and wove-all using much the same kinds of equipment for decades, generations, sometimes centuries How similar are the clothes and utensils, the materials of buildings, the means of conveyance that we see in the background of a Renaissance picture to those that we can make out on a Greek vase! How little material progress took place over a thousand years! That gives us a sense of how vast a change capitalism would bring when it finally burst upon the historic scene MARKET SOCIETY EMERGES _ Thus we see that far from representing an eternal "human nature," capitalism comes as a volcanic disruption to time-honored routines of life We begin to understand the immense inertia that prevented capitalism from developing in most earlier societies From one of these societies to another, of course, different obstacles and barriers stood in the way of creating an economic way of life • Appendix: How the Banking System Works 243 Assume now that the Smith Corporation, a well-known firm, comes in for a loan of $800,000 Our bank is happy to lend them that amount But making a loan does not mean that the bank now pays the company in cash out of its vaults Rather, it makes a loan by opening a new checking account for the firm and by crediting that account with $800,000 (Or if, as is likely, the Smith firm already has an account with the bank, it will simply credit the proceeds of the loan to that account.) Our new balance sheet shows some interesting changes: ORIGINAL BANK Assets Liabilities $1,000,000 Cash and at Fed 800,000 Loan (Smith Corp.) $1,800,000 Total Original deposits $1,000,000 800,000 New deposit (Smith Corp.) $1,800,000 Total There are several things to note about this transaction First, our bank's reserves (its cash and deposit at the Federal Reserve) have not yet changed The $1 million in reserves are still there Second, notice that the Smith Corporation loan counts as a new asset for the bank because the bank now has a legal claim against the company for that amount (The interest on the loan is not shown in the balance sheet; but when it is paid, it will show up as an addition to the bank's cash.) Third, deposits have increased by $800,000 Note, however, that this $800,000 was not paid to the Smith firm out of anyone else's account in the bank It is a new checking account, one that did not exist before As a result, the supply of money is also up! More about this shortly Was it safe to open this new account for the company? Well, we might see whether our reserves are now sufficient to cover the Smith Corporation's account as well as the original deposit ac­ counts A glance reveals that all is well We still have $1 million in reserves against $1.8 million in deposits Our reserve ratio is much higher than the 20 percent required by law It is so much higher, in fact, that we might be tempted to make another loan to the next customer who requests one, and in that way further increase our earning capacity But an experienced 244 Appendix: How the Banking System Works banker shakes his head "The Smith Corporation did not take out a loan and agree to pay interest on it just for the pleasure of letting that money sit with you," he explains "Very shortly, the company will be writing checks on its balance to pay for goods or services; and when it does, you will need every penny of the reserve you now have." That, indeed, is the case Within a few days we find that our bank's account at the Federal Reserve Bank has been charged with a check for $800,000 written by the Smith Corporation in favor of the Jones Corporation, which carries its account at another bank Now we find that our balance sheet has changed dramatically, as we can see below: ORIGINAL BANK Assets Liabilities $ 200,000 Cash and at Fed 800,000 Loan (Smith Corp.) Original deposits Smith Corp deposits $1,000,000 Total $1,000,000 Total $1,000,000 The borrower uses the loan, reducing its deposits to zero Let us see exactly what has happened First, the Smith Corporation's check has been charged against our account at the Fed and has reduced it from $900,000 to $100,000 Together with the $100,000 cash in our vault, this gives us $200,000 in reserves Second, the Smith Corporation's deposit is entirely gone, although its loan agreement remains with us as an asset Now if we refigure our reserves, we find that they are just right We are required to have $200,000 in vault cash or in our Federal Reserve account against our $1 million in deposits That is exactly the amount we have left Our bank is now fully "loaned up." But the banking system is not yet fully loaned up So far, we have traced what happened only to our bank when the Smith Corporation spent the money in its deposit account Now we must trace the effect of this action on the deposits and reserves of other banks We begin with the bank in which the Jones Corporation deposits the check it has just received from the Smith Corporation A look on the next page will show you that the Jones Corporation's Appendix: How the Banking System Works 245 bank now finds itself in exactly the same position as our bank was when we opened it with $1 million in new deposits, except that the addition to this second-generation bank is smaller than the addition to the first-generation bank SECOND BANK Liabilities Assets Cash and at Fed Total $800,000 $800,000 Deposit Oones Corp.) Total $800,000 $800,000 The assets of a new (second-generation) bank have risen As we can see, our second-generation bank has gained $800,000 in cash and in deposits Since it needs only 20 percent of this for required reserves, it finds itself with $640,000 excess reserves, which it is now free to use to make loans as investments Suppose that it extends a loan to the Brown Company and that the Brown Company shortly thereafter spends the proceeds of that loan at the Black Company, which banks at yet a third bank The balance sheets below show how the total deposits will now be affected SECOND BANK (AFTER BROWN CO SPENDS THE PROCEEDS OF ITS LOAN) Liabilities Assets Cash and at Fed Loan (to Brown Co.) Total $160,000 640,000 $800,000 Deposits Oones Corp.) Deposits (Brown Co.) Total $800,000 $800,000 THIRD BANK (AFTER BLACK CO GETS THE CHECK OF BROWN CO.) Liabilities Assets Cash and at Fed Total $640,000 $640,000 Deposit (Black Co.) Total $640,000 $640,000 Here is a repetition of the same process, as the Second Bank uses its lending capacity to finance Brown Co As the next figure makes clear, the process will not stop here, but can continue from one bank to the next as long as any lending power remains Notice however that this lending power gets smaller and smaller and will eventually reach zero 246 Appendix: How the Banking System Works Bank A New deposits $1,000,000 _ Bank D $800,000 $640,000 $510,000 :,:: C: ro � D 3: 3: Vl :,:: u _ ,. Q) J Bank e :,:: Required -� , , -,,.-� �- � reserve ,,,.,,_ -·.,.,- ro a; > Excess reserve $800,000 , � Loan Bank B C: ro $640,000 C: ·ro Oil ro a; > "O ro Loan New deposit account = new money EXPANSION OF THE MONEY SUPPLY* If we now look at the bottom of this last figure, we will see something very important Every time any bank in this chain of transactions has opened an account for a new borrower, the supply of money has increased Remember that the supply of money is the sum of currency outside the banking system (i.e., in our own pockets) plus the total of demand deposits As our chain of banks kept opening new accounts, it was simultaneously expanding the total check­ writing capacity of the economy Thus, money has materialized, seemingly out of thin air Now how can this be? If we tell any banker in the chain that he has "created" money, he will protest vehemently The loans he made, he will insist, were backed at the time he made them by excess reserves as large as the loan itself Just as we had $800,000 in •we have followed how increases in bank lending can lead to a rise in the money supply The same process can take place if a bank uses its excess reserves to buy investments, such as government bonds, instead of lending its money For simplicity's sake we have omitted the investment process here Appendix: How the Banking System Works 247 excess reserves when we made our initial loan to the Smith Corporation, so every subsequent loan was always backed 100 percent by unused reserves when it was made Our bankers are perfectly correct when they tell us that they never, never lend a penny more than they have Money is not created in the lending process because a banker lends money he doesn't have Money is created because you and I generally pay each other by checks that give us claims against each other's bank If we constantly cashed the checks we exchanged, no new money would be created But we not We deposit each other's checks in our own bank accounts; and in doing so, we give our banks more reserves than they need against the deposits we have just made These new excess reserves make it possible for our banks to lend or invest, and thereby to open still more deposit accounts, which in tum lead to new reserves This all sounds a little frightening Does it mean that the money supply can go on expanding indefinitely from a single new deposit? Wouldn't that be extremely dangerous? MONEY AND DEBT All this gives us a fresh insight into the question of what money is We said before that it is whatever we use to make payments But what we use? The answer is a surprising one We use debts-specifically, the debts of commercial banks Deposits are, after all, nothing but the liabilities that banks owe their customers Furthermore, we can see that one purpose of the banking system is to buy debts from other units in the economy, such as businesses or governments, in exchange for its own debts (which are money) For when a bank opens an account for a business to which it has granted a loan or when it buys a government bond, what else is it doing but accepting a debt that is not usable as money, in exchange for its deposit liabilities that are usable as money And why is it that banks create money when they make loans, but you or I not, when we lend money? Because we all accept bank liabilities (deposits) as money, but we not accept personal or business IOU' s to make payments with You cannot buy groceries with a General Motors IOU, but you can with a Chase Manhattan IOU-a check drawn on your account there 248 Appendix: How the Banking System Works It would of course be very dangerous, but there is no possibility that it can happen For having understood how the supply of money can expand from an original increase in deposits, we may now understand equally well what keeps an expansion within bounds Not every loan generates an increase in bank deposits If our bank had opened a loan account for the Smith Corporation at the same time that another firm had paid off a similar loan, there would have been no original expansion in bank deposits In that case, the addition of $800,000 to the Smith account would have been exactly balanced by a decline of $800,000 in someone else's account Even if that decline would have taken place in a different bank, it would still mean that the nation's total of bank deposits would not have risen, and therefore no new money would have been created Thus, only net additions to loans have an expansionary effect Such a net addition arises when the Fed buys U.S securities (See page 118.) There is a limit to the rise in money supply from a single increase in deposits As our figure shows, in the chain of deposit expansion each successive bank has a smaller increase in deposits, because each bank has to keep some of its newly gained cash or checks as reserve Hence the amount of excess reserves, against which loans can be made, steadily falls Further, we can see that the amount of the total monetary expansion from an original net increase in deposits is governed by the size of the fraction that has to be kept aside each time as reserve If each bank must keep one fifth of its increased deposits as reserves, then the cumulative effect of an original increase in deposits, when it has expanded through the system, is five times the original increase If reserves are one fourth, the expansion is limited to four times the original increase, and so on The monetary expansion process can work in reverse Suppose that the banking system as a whole suffers a net loss of deposits Instead of putting $1 million into a bank, the public takes it out in cash The bank will now have too few reserves and it will have to cut down its loans or sell its investments to gain the reserves it needs In tum, as borrowers pay off their loans, or as bond buyers pay for their securities, cash will drain from other banks, who will now find their reserves too small in relation to their deposits In turn, they will therefore have to sell more investments or curtail still other loans, and this again will squeeze still other banks and reduce their reserves, with the same consequences Appendix: How the Banking System Works 249 Thus, just as an original expansion in deposits can lead to a multiple expansion, so an original contraction in deposits can lead to a multiple contraction The size of this contraction is also limited by the size of the reserve fraction If banks have to hold a 25 percent reserve, then an original fall of $100,000 in deposits will lead to a total fall of $400,000, assuming that the system was fully loaned up to begin with If they had to hold a 20 percent reserve, a fall of $100,000 could pyramid to $500,000 The expansion process may not be fully carried through We have assumed that each bank in the chain always lends out an amount equal to its excess reserve, but this may not be the case The third or fifth bank along the way may have trouble finding a credit-worthy customer and may decide-for the moment, anyway -to sit on its excess reserves Or borrowers along the chain may take out cash from some of their new deposits and thereby reduce the banks' reserves and their lending powers Thus the potential expansion may be only partially realized The expansion process takes time Like the investment multiplier process, the expansion of the money supply encounters many frictions in real life Banks not instantly expand loans when their reserves rise; bank customers not instantly expand the proceeds of bank loans The time lags in banking are too variable to allow us to predict exactly how long it will take for an initial increase in new deposits to work its way through the system, but the time period is surely a matter of months for two or three "rounds." The mechanics of the expansion of the money supply now enable us to understand better the role of the Federal Reserve The Fed, we recall, has three means of exerting its authority: raising or lowering the amount of required reserves; changing the bank borrowing rate (discount rate); and buying or selling U.S bonds (open-market operations) All of these have the same end result They increase or decrease the excess reserves of banks As a consequence, they allow the expansion process-or the contraction process-to start on its course And that's how the banking system works! Index Accumulation, disruption of, 26 Advertising, 180-81 Agriculture and productivity, 147 Airlines and regulation, 187 Alcoa, 185 Aluminum industry, 185 American Motors, 179 fn Antitrust, 185 Aristocrats, impoverished, 7-8 Armaments and productivity, 152 Assembly lines, 55 Assets, definition of, 241 AT&T (American Telephone and Tele­ graph Company), 34-35, 73, 79, 87, 93, 94, 185 Automobile industry and productivity, 149 Auto purchases, 82 "Bads," economic, 173 Balance of payments, 208, 211, 215 Balance sheet defined, 241 Ball, George, 227 Banks, 109-12 central, 134, 249 (see also Federal Reserve System) how system works, 241-49 investment, 112 reserve ratios, 110 runs on, 111 Berle, A A., 188 Bethlehem Steel, 185 Big business (see Business, big) Blacks and poverty, 40 Blacks and productivity, 193 Bonds, Federal Reserve, 119 government, 96 Borrowing, business, 73 Bretton Woods agreement, 33 Britain (see England, Great Britain) British Petroleum, 135 fn Budget, federal, 138, 139 Budget trimming, 141 Business big, 27, 35-37, 51-54, 138, 179-89 (see also Multinational corpora­ tions) disclosure, 188 and economies of scale, 53 efficiency, 182 Fortune 500, 184 innovation, 185 nationalization, 187 profits, 182 regulation, 186 oligopolies, 179-89 and power, 183-89 small, 34-35 Business cycles, 85, 103 Business power, 137 Buyers, 19, 159 (see Demand) Capital (Marx), 24, 27 Capital accumulation of, 22, 25-26, 31 and growth, 22 quality and quantity of, 48-49 Capital equipment, 64, 84, 149 Capital expenditures, 84-85 Capital (investment) goods, 64, 84 Capitalism, 3, 4, 5, 6, 104, 138 crisis of, 237-39 and democracy, 50 disequilibrium, 133 instability of, 27, 28 Marx's theory, 25-29 Capitalist planning, 238-39 Cash, 108-10 Charity and transfers, 66 Checks, as money, 108-9 China, 228, 234 Chrysler, 128, 152, 179 fn., 185 Churchill, Winston, 212 Oass struggle, 25, 27 Gasses, social, 38-42 COLA (cost-of-living adjustment), 137 Common good, 201 Communism and Marx, 29 Communist Manifesto, 24 Competition, 19-20, 179-80 cutthroat, 136 Conservative view of government and inflation, 100-2 of supply-side economics, 104-6 Consolidated Edison, 101 Consumer goods, 64 Consumer information, 169 Index Consumer Price Index, 129 fn Consumer protection, 188 Consumer sovereignty, 180, 183 Consumer spending, 80-83 Consumption, 74 durables and nondurables, 81, 82 during depression, 81-82 during inflation, 82 during World War II, 81 and GNP, 82 household, 81-83 personal, 67 private, 65 public, 65 Controls, wage-price, 142-44 Corporate executive, responsibility of, 184 Corporate power, 182-89 Corporations, 34-35 (see Big business) Costs and technology, 135 Credit, 135 fn Currency, 108, 109, 112 (see Money) Cycles, business, 85, 103 Defense, 172 (see also Military spending Deficit spending, 93-98 Deflation, 136 Demand, 71, 158, 180, 234 (see also Supply and demand) foreign, 78, 208-11 Demand curve, 159 Demand gap, 74, 76, 77 closing of, 93 Demand management, 102-3 Democratic political institutions, 15 Denison, Edward, 69 Denmark, 145, 220 Depression Great (see Great Depression) history of, 133-34 Diminishing marginal utility, 158 fn Discount rate, 117, 249 Discrimination and earnings, 193-95 Distribution of income, 38-42 altering, 196-99 American Indians, 195 blacks, 193 change in, 49-51 discrimination and, 193-95 education and, 196-97 equity and equality, 199-201 fairness, 198-99 Hispanics, 195 inequality, 200-1 output and, 192 251 productivity and, 191-95 by sex, 194 Division of labor, 14, 21-22, 55 Dollar balance on current account, 208 defending the, 213-19 equilibrium with other currencies, 212 falling, 205-11 problems of, 211-13 market for, 208-11 as world currency, 216, 217 Earnings (see Distribution of income, Wages) Easy money, 117 Economic Consequences of the Peace, 32 Economic freedom, 4, 9, 235 Economic growth, 45-49, 122 Economies of scale, 53 Economists, great Keynes, John Maynard, 29-33 Marx, Karl, 23-29 Smith, Adam, 17-23 Economy mixed, 30 unification of, 58 Edsel, 180 Education and earnings, 196-97 Employers, big, 36 Employment (see also Income, Labor, Unemployment) federal vs state and local, 44 full, 99 Engels, Friedrich, 24 England, 135 fn., 187 (see also Great Britain) Entitlement, 59, 138 Environmental damage, 188 Environmental deterioration, 69 Equality, 199-202 Exchange rate, 206, 212, 213 Expectations of inflation, 137 public, 138 Expenditures (see Consumption, In­ vestment, Government) capital, 84-85 public vs private, 101 Export balance, 67 Externalities, 173 Exxon, 36, 94-95, 228 Factors of production, 6, Federal Reserve System, 101, 110-U, 132 252 Index Federal Reserve System (cont.) controlling money supply, 116-19 currency issuing, 112-13 "dirty" floating, 216 discount rate, 117 open-market operations, 118-19 reserve ratios, 110, 117 Feudalism, Financial institutions, 192 Ford Motor Company, 13, 149, 179 fn., 180I 185I 205 assembly lines, 55 Foreign investment of U.S., 225 Foreign trade (see International trade) Fractional reserve system, 111-12 France, 187, 230, 238 Freedom economic, 4, political, 15 French wine, 206 Friedman, Milton, 30, 121, 183, 187, 249 Galbraith, John Kenneth, 187 General Theory of Employment Interest and Money, 30 Germany, 15, 113, 185, 187, 188, 207 (see also West Germany) GM (General Motors), 52, 149, 159, 179 fn., 184, 185, 205, 220, 222 GNP (Gross National Product), 56, 76, 79, 93, 100-2 consumption and, 82 correcting for inflation, 46-47 current or nominal, 46-47 definition, 63-64, 65, 67 fluctuation, 71-74, 78-79 and government, 90-91, 93, 100-6 increase in, 45-49 international trade and, 205 "real," 47, 68 Gold, 128, 216 and money, 113-15 Gold certificates, 113 Gold standard, 216-17 fn Goods capital, 64, 84 consumers, 64 durable and nondurable, 81 final, 68 goods and services, 64, 65, 68 investment, 64-65 public, 170-73, 236 Gosplan (Soviet planning agency), 231 Government agencies, 57 bonds, 118, 119, 249 borrowing, 78 budgetary policies, 103 buyer, 90 deficit spending, 93-98 as demand manager, 102-3 as economic institution, 43-44 as employer, 44 and GNP, 90-91, 93, 100-6 goods supplied by, 20 and inflation, conservative view, 100-2 and inflation, liberal view, 100-2 intervention, 57, 59 investment by, 66 military spending, 90-91, 103 output, 77 power to print money, 97 purchases, 56, 67 regulations, 152, 186 role of, 78 as a sector, 92-93 services, 77 spending, 31, 76, 91-93, 99-106 1981 figures, 91 transfer payments, 56, 66, 72, 89, 90, 91 welfare and warfare, 90-91 Great Britain, 238 (see also England) Great Depression {1930s), 30, 59, 100, 120, 128 Growth capital and, 22 cause of, 21-22 economic, 45-49, 122 long-range, 150 population, and GNP, 47-48 real per capita, 47-48 slowdown in, 145-53 sources of, 48-49 Hand, Invisible, 20-21 Health care, 70 History capitalism and, 25 of depressions, 133-34 Hong Kong, 197, 222, 224 Households, 37-43 Housing, low cost, 104 IBM, 128, 185, 220, 222, 228 ICC (Interstate Commerce Commis­ sion), 186 Ignorance of consumer, 168-70 Index IMF (see International Monetary Fund) Income distribution, 38-42 and inflation, 124-28 shares by family, 127 Income Distribution, 42 fn Income tax, negative, 198 Incomes policy, 142, 144 fn Indexing, 132-33, 137 Industrial Revolution, 12-15 Industrial sector, 31 Industrial society, crisis in, 239 Inequality, 193-95, 200-1 Inflation, 75, 76, 212, 213, 237 acceleration, 129-31 causes, 133-37 combating, 139-44 Confederate States and, 129 consumption during, 82 correcting GNP for, 46-47 costs of, 131 expectations affect, 137 and financial assets, 130 Germany and, 129 history of, 133-35 and income distribution, 126-28 and printing money, 97 and real buying power, 125 savings and, 82 stagflation, 120 theories, 132-33 threats of, 129-31 and unemployment, 131 Inflationary drift, 136 Inheritance, 191, 200 Inheritance taxes, 197 Interest rates, 117, 128 International Chamber of Commerce, 221 International Monetary Fund (IMF), 217 International trade balance on current account, 206 GNP and, 205 market for capital transactions, 20911 market for current transactions, 2089 Inventories, 85 Investment, 75, 76, 86, 152-53, 192 abroad, 210 by government, 66 and inventories, 85 private, 67 stock market and, 87 253 Investment demand, 83-88 Investment goods, 64-65 Invisible Hand, 20-21 Israel, 96 fn., 220 Italy, 187 Japan, 69-70, 145, 146, 147, 149-51, 153, 185, 207, 218, 222, 226, 230, 238 Kaiser Motors, 54 Keynes, John Maynard, 29-33, 107, 123 Labor (see also Unions) demand for, 22-23 division of, 14, 21-22, 55 quality, 48-49 quantity, 48 proletarianization of, 27 supply of, 22-23 unions, 238 working class, 39-41 Laissez-faire, 16, 31, 187 Law and order, 77 Liabilities, 241 Liberal view, of government and inflation, 100-2 Liberman, E G., 232 Liberty, 21 Lockheed Aircraft, 187 Luck, 192 Luddites, 14 M (Money), 26-27 (see also Money) Macroeconomics, 63 Manufacturing, 36 Market system (see also Capitalism) definition, efficiency, 164-65 emergence, 5-9 failure of, 168-78, 236-37 ignorance, 168-69 perverse behavior, 169 vs planning, 233-36 poverty and, 236 prices in, 160-62 public goods and, 170-73, 236 self-enforcing, 165-67 self-regulating, 20-23 strength of, 177-78 Marx, Karl, 23-29, 51, 52, 54, 107, 237 Marxism, For and Against, 27 fn Maximize profits, 235 Mergers, 53-54 Mexico, 69, 220, 222, 224 254 Index Microeconomics, 157 Middle class, 39-40 Military spending, 90-91, 103 Millionaires, 42 and productivity, 191 Mining, 148-49 Modem World System, Monetarism, 121-23 Monetizing the debt, 101, 118-19 Money (see also Capital, Currency, Dollar, Exchange rate) commodities used as, 115 and debt, 247 definition, 108-9, 115 gold, 114-15 gold certificates, 113-14 government power to print, 97 paper and gold, 112-15 printing, 97, 113 Money illusion, 125-26 Money supply control of, 116-19 expansion, 246-49 Monopoly, 179 costs of, 180-82 Moral values, 236-38, 240 Morgan, J P., 53 Mutlinational corporations, 183, 220-29 economics of production, 223-25 expansion abroad, 209 15 top, 223 "hostage" problem, 225 problems, 225-26 production economics, 223-25 underdeveloped world and, 227-29 Multiplier, 86 Nader, Ralph, 188 Nationalization of business, 187 Negative income tax, 198-99 Nestle Chocolate, 221 Netherlands, 221 Nevins, Allan, 55 fn New Deal, 106 Oil crisis, 208-9 Oil price rises, 133-34, 136 Oil production, 148 Oligopoly, 179 O'Neill, Tip, 139 OPEC (Organization of Petroleum Exporting Countries), 136, 138, 208-9 Open-market operations, 118, 249 Output, 71 (see also Productivity) government, 77 public, 44 total, 45-49 (see also GNP) U.S., 78 "Paper" gold, 217 Partnerships, 34-35 Pen, Jan, 42 fn PepsiCo, 220 Philippines, 220 Philips Lamp Works, 221 Planning capitalist, 238-39 market vs., 233-36 Soviet, 230-33 Yugoslavia, 233 Political freedom, 15 Political lobbying, 188 Pollution, 69, 237 Pollution control, 188 "bads," and, 173 environmental legislation, 16 by regulation, 174-75 by subsidizing, 176 by taxing, 175-76 Poor, the (see Poverty) Population, growth and GNP, 47-48 Poverty, 4, 69, 236, 237 characteristics of the poor, 38, 40, 190 definition, 38 diminution of, 50-51 and productivity, 191 real income and, SO working poor, 38-39, 105 Price(s) control of, 142-44 of a dollar, 205-7 equilibrium, 162-63 nineteenth century, 135 "ratchet tendency," 135-36 runaway, 129-30 and supply and demand, 158-62 that "clear" the market, 160 time involved, 70 Price rationing, 162-63, 165, 167 Price system, 157-59 Private property, Production (see also Externalities, Factors of production, GNP, Goods, Output) factors of, 6, Productivity, 73, 145-53 challenge from abroad, 149-51 hard and soft, 152 Index and income distribution, 191-95 millionaires and, 191 poverty and, 191 U.S vs other nations, 145-53 Profit, 26, 84, 182 maximization, 235 Propensity to consume, 80-82 Propensity to save, 151-52 Proprietorships, 34-35 Public debt (see Deficit spending) Public goods, 170-73, 236 Public output, 44 Public sector (see Government) Race income and, 193-95 poverty and, 40, 190 Railroads, 186 Rationing gas, 166-67 price, 162-63, 165, 167 Reagan administration and budget, 138, 139 Recession, 76, 103, 126 Reconstruction Finance Corporation (RFQ, 106 Regulation of business, 152, 186 Rent controls, 170 Reserve currencies, 216 Reserve ratios, 110, 117 Ricardo, David, 32 Riches (see also Millionaires, Wealth), 192 Royal Dutch/Shell, 221 Rugged individualism, 59, 138 Salaries (see Wages) Saudi Arabia, 145, 234 Save, propensity to, 151, 152 Savings, 153 household, 72, 74-75 and inflation, 82 national rates of, 80 percent of income, 80 Savings deposits, 111 Scale, economies of, 53 SOR, Special Drawing Right, 217 Sectors, 77, 92-93 interlocking of, 74-76 Serf, Service industries, 147-48, 149 Sex, income and, 194 Shortage, 163-64 Singapore, 222, 224 255 Slaves, Small business, 34-35 Smith, Adam, 13, 14, 17-23, 71, 73 fn , 77, 107, 123 Soap industry, 179 fn Social Security, 16, 56, 57, 66, 72, 89, 91, 127, 133, 134, 137 Socialism, 15 Socialist planning, 230-33 Soviet Union, 195, 228, 230 interest in, 232-33 planning in, 231-33 profits in, 232 Spending business, 73-74 consumer, 80-83 government, 31, 76, 91-93, 99-106 government deficit, 93-98 household, 72 Stagflation, 120 Standard of living, 145 Steel industry, 146, 147, 149-51 Stock market, 87 Stocks, 128, 210 Subsidies, 66, 176 (see also Transfer payments) Supply and demand, 158-59 balance of, 160-62 Supply curve, 159-60 Supply-side economics, 93 fn , 104-6, 122 fn Surplus, 163, 164 Surplus value, 26, 27 Sweden, 15, 69, 145, 187, 195, 221, 230, 238 Swiss francs, 216 Switzerland, 141, 145, 221 Taiwan, 224 Tax cuts, 105 Taxes, 75, 77 on pollution, 175-76 Technology, 58 effects of, 13-15 and lower costs, 135 medieval, 10 and pollution, 173 precapitalist, 9-11 Thatcher, Margaret, 134, 135 fn Theories of Surplus Value, 24 Theory of Moral Sentiments, 18 Tight money, 117, 140 Time deposits, 111 TW (Tax Incentive Plans), 142 Trade unions (see Unions) 256 Index Transfer payments, 56, 66, 72, 89, 90, 91 Transportation, 186 Treasury securities, 10 Truth-in-advertising laws, 169 Underdeveloped world, 227-28 Underemployment equilibrium, 31 Unemployment, 76, 100, 131, 141-42, 213, 237 Unemployment compensation, 66 Unemployment insurance, 92 Union power, 136, 137 Union wages, 197 Unions, 23, 54, 188, 196, 238 Upper class, 39, 41 Urbanization, 58 U.S bonds, 249 U.S foreign inveshnent, 221 USSR (see Soviet Union) U.S Steel, 52, 53, 185 Usury, Utility diminishing marginal, 158 fn Utility industry and productivity, 148 Volkswagen, 151, 205 Voting, public goods and, 170-73 Wage-price controls, 142-44 Wages (see also Income, Distribution of income) control of, 142-44 minimum, 196-97 "ratchet tendency," 135-36 Wallerstein, Immanuel, Wealth (see also Capital, Distribution of Income) distribution, 39-42, 191-92 Wealth of Nations, 17, 21 Welfare and warfare, 90-91 West Germany, 80, 141, 145, 146, 147, 151, 153, 195, 218, 238 (see also Germany) Women's Liberation movement, 195 Workers (see Labor) Working class, 39, 41, 128 Working poor, 105 World Bank, 217 World War II, consumption during, 81-82 Yugoslavia, 233 f4 Reward Book Econom ics "The people who are really eager to understand economics are not students who want to pass a course, but men and women in the real world who need to make their way intelligently through life That is why our text unabashedly announces that this is the economics you ought to know-not to get rich, and not to have a particular point of view-but simply to be an effective investor, an educated business person, an informed worker, or just a good citizen." -Robert Heilbroner and Lester Thurow Unlike any previous work on economics for the general reader, EC ONOMIC S EX PLAINED is easy to grasp wi thout being over­ simplified, authoritative without being ponderous, concerned with teaching about the controversies of our times without preaching about th e m Written by two of A merica's most famous economists, it is based on the conviction that what today's America ns really want is to have economics explained-concisely, simply and accurately, without tricks, acknowledging what economists not know, as well as explaining what they In this brief, fascinating tour of modern economics Heilbroner and Th urow explain : • what capitalism is, and how the American capitalist system works • what the words we hear on TV-gross national product, government deficits, the Federal Reserve System-really mean • the pros and cons of "supply side" economics • what economists know about the causes of in flation and recession • how markets work • where the economy may be heading ROBERT L HEILBRONER is Norman Thomas Professor of Economics at the New School for Social Research in New York The au thor of many notable books, Dr Heilbroner is perhaps best known for his The Worldly Ph ilosophers, the most celebrated in troduction to economics of this genera tion J LE STER C THUROW is a professor at the Al fred;P Sloan School of Managemen t, Massachusetts Institute of Technology Hi s technical wri tings have earned him an enviable repu tation among professional economists, and he is known to millions of nonprofes sionals both through his Newsweek columns and his recen t best-selling book The Zero Su m Society PRENTICE-HALL, Inc Englewood Cliffs, New .. .Economics ExfJlained Roberl L Heilbroner and Lester C Thurow Prentice-Hall, Inc., Englewood Cliffs, New Jersey 07632 Book Design by Joan Ann Jacobus Art Director: Hal Siegel Economics Explained. .. Zealand 10 Library of Congress Cataloging in Publication Data Heilbroner, Robert L Economics explained Includes index Economics I Thurow, Lester C II Title 81-20975 330 HB171.H479 AACR2 ISBN0-13-229708-6... the social system with which economics is mainly concerned But we have not yet gained a sense of what economics itself is about Perhaps we can see, however, that economics is mainly "about" capitalism-that