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Sunday, July 31, 2011

The Yin and Yang of Economics

According to Wikipedia, the Asian philosophy of Yin Yang describes how "seemingly contrary forces are interconnected and interdependent in the natural world, and how they give rise to each other in turn." Furthermore, "Many natural dualities—e.g. dark and light, female and male, low and high, cold and hot— are thought of as manifestations of yin and yang (respectively)."

Economics, with its concept of equilibrium, involves similar dualities. The fundamental principle of economics, for example,  is that buyers want low prices and sellers want high prices.  The result is that prices stay in check - unless, of course, you have a Federal Reserve bent on keeping prices low.  Then it will, over time, totally devalue the monetary unit - but that is another story.  It is important, in the context of Yin and Yang, in that it seems that by explicitly seeking stable prices the Federal Reserve, in fact, causes inflation over time. When your grandmother said that the dollar doesn't buy what it used to, it was her way of saying there has been significant inflation.

The two-sided impact is always there but many times ignored or not realized.  An important example of the Yin Yang type of duality in economics involves interest rates.   It is common to laud the Federal Reserve (especially by the Chairman himself) for its policy of lowering interest rates to increase economic activity.  After all, lower interest rates make it easier for business and other economic entities to borrow and thereby increase economic activity.  But there is another effect of lowering interest rates.  It reduces income of people living on fixed income, (mostly retirees, who in fact have a high marginal propensity to consume) and, in fact, produces an incentive to take greater risk in the investment markets. Today, for example, retirees who can't live on the income produced by bank savings accounts or money market funds have put a greater percentage of assets in dividend paying stocks.

The macroeconomic impact of lowering income for investors who seek low risk investments should, it would seem, always be brought into the analysis but especially in demographic situations like the present-- where in the U.S. and other countries there is a significant aging of populations occurring.  To often it's not.  In the end, policy makers sit around after their actions have had their impact and try to figure why employment is stagnant.  Maybe a significant contributing factor is the loss of income from short-term rates being driven to zero.

Every economic policy has a positive and a negative impact.  Every policy has a Yin and Yang.  Both need to be understood, especially in relation to the environment in which they are undertaken.

1 comment:

  1. Great post, Robert.

    Another effect of lowered interest rates is that it also encourages capital waste by building projects that would not be profitable if interest rates were to rise to a higher level.

    The interest rates hide the real state of savings in the economy. I look at the crumbling infrastructure where I live and recognize that there's going to be a lot more debt or taxes in our future!