Economists look at how pieces of the economy are connected to (and influence) each other, such as the idea of supply and demand. If the demand for labor goes up and the supply goes down, then wages for labor will increase. If wages increase then the cost of goods increase (to cover the wages) which means higher prices. Higher prices is another term for inflation.
The general rule is that if an economy is growing too quickly, we get inflation. The cure for inflation is to slow the economy down which the government tries to do by raising interest rates. By making money more expense (by increasing the cost of borrowing money), businesses slow down and the economy slows down and prices fall again.
At least that is the theory. Rules of thumb like this example build up over time. Economists study the great depression and the stock market crash of the 1920's for decades and eventually rules of thumb about how the economic system works appear. Economies are so complex, you cannot really see all the interactions and understand it so you need rules of thumb that explain things well enough but are simple enough to use.
I just wonder if the game is changing so fast and much that our rules of thumb based on the past century of national economies are no longer appropriate.
the new rules
This morning, I heard a news story about inflation which is what got me thinking about all this. The truth is, I am rather puzzled by inflation. The person being interviewed pointed out that the national inflation rate has stayed around 2% for years, but I dont get it.
How is it that prices for goods never seem to go up much? We pay $3 for a gallon of gas (diesel actually) in Seattle. Our heating bill went up by 4x this winter and housing prices have gone through the roof everywhere. The cost of gold and platinum is at an all time high. In fact, everywhere I look (except for computers), prices are way up so how is the national inflation index only 2%...?
Thinking about inflation, I got to thinking about closed-systems. Economies used to be largely closed systems. Raw materials would be brought into the system from other countries, but the bulk of the value was manufactured in our country. Thus the Fed and businesses only had to worry about the factors within the nation. All those supply and demand rules about wages and inflation were refined in the past century, so they are based on the idea of a closed national system.
But we dont have a closed national system anymore.
the global economy
The economy today has expanded beyond national into a global system which turns rules of thumb, like supply and demand, on their heads. Wages in our nation arent as important to inflation anymore because the jobs can just move to a cheaper country. If manufacturing costs get too high in our nation, prices dont go up but rather those jobs move to China.
Another rule of thumb economists use to judge the economy is the unemployment rate. If too many people are employed (a low unemployment rate), there will be competition for jobs and wages will rise, ie overheating the economy. This is why investors (inexplicably to many workers) like to see a healthy (ie high) unemployment rate but this rule of thumb is being changed by the massive influx of cheap labor coming into this country (like 10 million illegal workers). This supply of cheap labor prevents prices (and incomes) from rising because there is always someone willing to work for less money. And since they are illegal, you can forget about Unions or other groups pressuring for a living wage.
Of course, economists do take these inflows into account in their models but I have begun to wonder if the magnitude these inflows are now so large that they change the rules of the game. Not only has inflation stayed low because of importing cheap labor and exporting jobs but we have been importing amazing amounts of foreign capital. China, Japan and Korea continue to buy huge amounts of our Treasury Bonds, which keeps the US Dollar and our government out of bankruptcy despite the fact that we borrow more money every year (the national debt is now over $8 trillion dollars!).
So why has the inflation rate in our nation stayed so low? The answer is that globalization has changed the rules of the game and for the moment, the rules are in our favor. We continue to talk about inflation in the old terms, using our old rules of thumb, but globalism has made the picture a lot more complex.
I imagine this is clear to economists but I suspect it is completely UN-clear to citizens. We continue to make decisions on a personal level about household spending and on a macro level about education and infrastructure as if we are the only game in town. People still seem to see things as a closed-national system and that is a dangerous thing for the welfare of our children.