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Oversimplified Economics

By Rob Landley (TMF Oak)

"Debt is like nuclear power. It is a mighty force for good or evil, and you don't want to get any on you." -- Me, with apologies to Scott Adams.

AUSTIN, TX (July 23, 1999) -- On Monday, I discussed how there's really no such thing as money; it's all debt with a good makeup artist. Since paper money starts life as debt, it shouldn't surprise anybody that debt can create even more money out of thin air. Due to this amazing ability, debt is vital to the health of any modern economy. It works like this:

If I deposit a dollar in my bank account, the bank isn't going to sit on that dollar. It's going to loan it out to someone, often as a mortgage on a house. So the builder of the house gets paid my dollar and the new owners of the house are living in my dollar even while they work to pay off the mortgage (to give me a fresh dollar and change to replace the one they borrowed). Meanwhile, as far as I'm concerned, the dollar is still sitting there in the bank, earning interest. That one dollar is now in three places at once! It's magic!

This way, the economy is, to a certain extent, self-regulating. The government doesn't have to fire up the printing presses to print more money very often because when people need more money, they borrow it.

Of course, money by itself isn't worth anything. Sitting on an IOU that you can't cash in is no fun. Either you take it back to its source and redeem it, or you trade it for something from someone else. The ability to exchange money for goods and services is what gives money its value. Money is merely an economic lubricant making that exchange easier. And increasing the amount of money doesn't necessarily mean there's more stuff to buy with it.

If everyone in the country was suddenly granted a million dollars, the 99-cent Big Macs would run out rapidly. When the amount of money competing to buy the available goods and services goes up, prices go up. This is inflation. It doesn't just happen when the Feds crank up the printing presses and issue more dollar bills. The money-multiplying effects of debt also increase the money supply, and this too can cause inflation.

There is a man whose job is to make sure the growth of the money supply matches the growth of the goods and services there are to buy with it. Too little money and the economy's oil indicator light comes on. The lubrication dries up and people run out of money with which to buy stuff. That sort of thing can lead to a recession -- or worse. Yet too much money triggers inflation, decreasing the purchasing power of the money everyone has saved.

The man who tries to get the balance right is Alan Greenspan. He's the chairman of the Federal Reserve, and he influences the level of interest rates. Higher interest rates make it more expensive to borrow money, so people borrow less and the money supply contracts as they pay off their existing debts. Lower interest rates dump more borrowed money into the system, increasing the money supply.

Now you know why interest rates affect inflation, and why people hang on Alan Greenspan's every word so closely that an attack of gas on his part could redefine corporate policy in a dozen boardrooms.

The other variable that the Fed Chairman balances is economic activity. The goods and services that people trade require the use of raw materials, and if we use those up faster than they get replaced, we wind up with shortages. Shortages cause inflation from the other end -- the supply side -- by decreasing the amount of stuff all that money out there can buy. Who cares how much people will pay to buy houses once there's no more wood to build them this year?

The classic 25-year cycle of economic growth and recessions is in part driven by the availability of raw materials. When the economy is hurting, raw materials are cheap and plentiful because the businesses using them are weak and sickly. It could be a great time to start a business, assuming entrepreneurs can borrow the money to do so. At the peak of the boom, businesses grow and build more factories until their demand drives up the price of raw materials. They can even run low on the most valuable raw material of all: consumers for their massive output of products. At that point, profit margins dwindle, businesses lay off workers, and the economy sinks back into a recession, and the cycle repeats.

Economists have been very confused by the current economic boom because it isn't playing by the rules. Economic growth hasn't caused inflation, because the expansion has been driven by computers, which don't consume raw materials. A multi-million-dollar website can run on a dozen computers in an old garage, and stay running all year with only a little electricity. Websites consume memory, disk space, processor speed, and bandwidth in ever-increasing amounts, but each new generation of computer technology has figured out how to do twice as much with the same raw materials.

However, there is one raw material to watch, one that has been showing extreme stress and which is the only current limiting factor in the equation: people. Computer programmers can now earn six figures, and the main way companies hire any is to hire them away from other companies. Unemployment is very low, and that's inflating salaries. The Fool itself is hiring. Here in high-tech Austin, even unskilled labor is in short supply.

As long as the goods and services those salaries can buy keeps pace with the rising wages, inflation should remain under control and Greenspan won't have to raise interest rates to "cool down the economy." And even if he does raise rates, this economic boom -- now in its ninth year of expansion -- has lasted longer than any other in history, and shows no signs of slowing down.

As high-tech wages rise, more and more people flow into high-tech fields where the money is. Anyone with an artistic or literary bent can learn to create Web pages, and the Open Source movement is full of programmers teaching themselves faster than the overburdened colleges can crank out new graduates. Employment remains tight, but the economy is doing its best to adjust to the strain.

It's kind of neat to watch.

Have a great weekend! And, Rule Maker investors interested in Yahoo! (Nasdaq: YHOO), be sure to tune in to tomorrow's Motley Fool Radio Show when Tom and David Gardner will be interviewing Yahoo! President and CEO Tim Koogle ("T.K."). If the radio show isn't yet in your town, you can now listen online to both the live show and archives of past shows. Oh and by the way, Tom and David will also be interviewing yours truly about the MP3 digital music format, in light of MP3.com's recent initial public offering (IPO).

Next week, we tackle our monthly $500 question once again. Until then, Fool on!

- Oak

(And hey -- if you think any of your friends might learn some useful lessons from this article, click on "e-mail this to a friend" at the top-right corner of this page.)

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                  Day     Month  Year    History
        R-MAKER  -0.28%  -1.23%  12.09%  41.16%
        S&P:     -0.30%  -1.15%  10.97%  37.25%
        NASDAQ:  +0.30%   0.25%  22.79%  62.89%

Rule Maker Stocks

    Rec'd    #  Security     In At       Now    Change
   6/23/98   68 Cisco Syst    29.21     62.94   115.50%
    5/1/98   82 Gap Inc.      23.05     46.94   103.61%
    2/3/98   54 Microsoft     45.13     90.25    99.96%
   2/13/98   44 Intel         42.34     64.19    51.61%
   5/26/98   18 AmExpress    104.07    135.56    30.27%
    2/3/98   66 Pfizer        27.43     34.88    27.13%
    6/3/99   11 Delphi Aut    17.19     19.38    12.71%
   8/21/98   44 Schering-P    47.99     50.50     5.22%
    2/6/98   56 T. Rowe Pr    33.67     35.13     4.31%
   2/27/98   27 Coca-Cola     69.11     62.25    -9.92%
   2/17/99   16 Yahoo Inc.   126.31    145.75    15.39%

Foolish Four Stocks

    Rec'd    #  Security     In At     Value    Change
   3/12/98   20 Exxon         64.34     79.13    22.99%
   3/12/98   15 Chevron       83.34     93.81    12.56%
   3/12/98   20 Eastman Ko    63.15     70.44    11.54%
   3/12/98   17 General Mo    61.28     65.63     7.09%

Rule Maker Stocks

    Rec'd    #  Security     In At     Value    Change
    2/3/98   54 Microsoft   2437.28   4873.50  $2436.22
   6/23/98   68 Cisco Syst  1985.95   4279.75  $2293.80
    5/1/98   82 Gap Inc.    1890.33   3848.88  $1958.55
   2/13/98   44 Intel       1862.83   2824.25   $961.42
   5/26/98   18 AmExpress   1873.20   2440.13   $566.93
    2/3/98   66 Pfizer      1810.58   2301.75   $491.17
   8/21/98   44 Schering-P   2111.7   2222.00   $110.30
    6/3/99   11 Delphi Aut   189.09    213.13    $24.04
   2/27/98   27 Coca-Cola   1865.89   1680.75  -$185.14
    2/6/98   56 T. Rowe Pr  1885.70   1967.00    $81.30
   2/17/99   16 Yahoo Inc.  2020.95   2332.00   $311.05

Foolish Four Stocks
    Rec'd    #  Security     In At     Value    Change
   3/12/98   15 Chevron     1250.14   1407.19   $157.05
   3/12/98   20 Eastman Ko  1262.95   1408.75   $145.80

   3/12/98   20 Exxon       1286.70   1582.50   $295.80
   3/12/98   17 General Mo  1041.80   1115.63    $73.83

                              CASH    $255.59
                             TOTAL  $34752.78

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