Insider trading
A practice that was made illegal in the United States in 1934 and in the UK
The big hitters of the FINANCIAL MARKETS: pension funds, fund-management companies, INSURANCE companies, investment BANKS, HEDGE FUNDS, charitable endowment trusts. In the United States UK
Intellectual capital
The part of a country's or a firm’s CAPITAL or an individual’s HUMAN CAPITAL that consists of ideas rather than something more physical. It can often be protected through PATENTS or other intellectual property laws.
The cost of borrowing, which compensates lenders for the RISK they take in making their money available to borrowers. Without interest there would be little lending and thus a lot less economic activity. The charging of interest is contrary to Sharia (Islamic) law, being considered USURY. Some American states also have usury laws, imposing tough conditions on the terms set by lenders, although not actually prohibiting interest. Yet, as the recent rise of a substantial banking industry in Islamic Middle Eastern countries shows, when economic GROWTH is a priority, ways can usually be found to pay lenders to lend.
INTEREST is usually expressed at an annual rate: the amount of interest that would be paid during a year divided by the amount of money loaned. Developed economies offer many different interest rates, reflecting the length of the loan and the riskiness and wealth of the borrower. People often use the term “interest rate” when they mean the short-term interest rate charged to BANKS. For instance, when a CENTRAL BANK raises or cuts interest rates, it changes only the PRICE it charges to banks borrowing money overnight, expressed as an annual rate. BOND YIELDS are a better measure of the interest rate on loans that do not have to be repaid for many years. Unlike short-term interest rates, bond yields are determined not by central bankers but by the SUPPLY and DEMAND for MONEY, which is heavily influenced by the expected rate of INFLATION.
A helping hand for poor countries from rich countries. This, at least, is the intention. In practice, in many cases aid has done little good for its intended recipients (improved health care is a notable exception) and has sometimes made matters worse. Poor countries that receive lots of aid grow no faster, on average, than those that receive very little. By contrast, perhaps the most successful aid programme ever – the MARSHALL PLAN for rebuilding Europe after the second world war – involved rich countries giving to other hitherto rich countries.
During the second half of the 20th century rich countries gave over $1 trillion in aid to poor ones. During the 1990s, however, flows of official aid stagnated. In 2001, official aid was a little over $50 billion, roughly one quarter of the GDP of donor countries. On top of this were private-sector donations from NGOs (non-government organisations) worth an estimated $6 billion. Increasingly, such sums were exceeded by private FOREIGN DIRECT INVESTMENT. In an attempt to reinvigorate international aid, in 2000 the UN committed itself to eight ambitious Millennium Development Goals for reducing global poverty by 2015.
Why has aid achieved so little? Donations have often ended up in the OFFSHORE BANK accounts of corrupt politicians and officials in poor countries. MONEY has often been given with strings attached, so that much of this “tied” aid is spent on companies and corrupt politicians and officials in the donor country. War has ravaged many potentially beneficial aid projects. Moreover, some aid has been motivated by political goals – for example, shoring up anti-communist governments – rather than economic ones.
The lesson of history is that aid will often be wasted unless it is carefully aimed at countries with a genuine commitment to sound economic management. Analysis by the WORLD BANK sorted 56 aid-receiving countries by the quality of their economic management. Those with good policies (low INFLATION, a BUDGET surplus and openness to trade) and good institutions (little CORRUPTION, strong rule of law, effective bureaucracy) benefited from the aid they received. Those with poor policies and institutions did not. This accounts for the growing popularity of CONDITIONALITY in aid.
Investment
Putting MONEY to work, in the hope of making even more money. Investment takes two main forms: direct spending on buildings, machinery and so forth, and indirect spending on financial SECURITIES, such as BONDS and SHARES.
Traditionally, economic theory says that a country’s total investment must equal its total SAVINGS. But this has never been true in the short run and, as a result of GLOBALISATION, may never be even in the long run, as countries with low savings can attract investment from overseas and foreign savers lacking opportunities at home can invest abroad (see FOREIGN DIRECT INVESTMENT).
The more of its GDP a country invests, the faster its economy should grow. This is why GOVERNMENTS try so hard to increase total investment, for instance, using tax breaks and subsidies, or direct PUBLIC SPENDING on INFRASTRUCTURE. However, recent evidence suggests that the best way to encourage private-sector investment is to pursue stable macroeconomic policies, with low INFLATION, low INTEREST RATES and low rates of TAXATION. Curiously, economic studies have not found evidence that higher levels of investment lead to higher rates of GDP GROWTH. One explanation for this is that the circumstances and manner in which money is invested count at least as much as the total sums invested. It ain’t how much you do, it’s the way that you do
Financial ASSETS that “derive” their value from other assets. For example, an option to buy a SHARE is derived from the share. Some politicians and others responsible for financial REGULATION blame the growing use of derivatives for increasing VOLATILITY in asset PRICES, and for being a source of danger to their users. Economists mostly regard derivatives as a good thing, allowing more precise pricing of financial RISK and better RISK MANAGEMENT. However, they concede that when derivatives are misused the LEVERAGE that is often an integral part of them can have devastating consequences. So they come with an economists’ health warning: if you don’t understand it, don’t use it.
The world of derivatives is riddled with jargon. Here are translations of the most important bits.
• A forward contract commits the user to buying or selling an asset at a specific price on a specific date in the future.
• A future is a forward contract that is traded on an exchange.
• A swap is a contract by which two parties exchange the cashflow linked to a liability or an asset. For example, two companies, one with a loan on a fixed INTEREST RATE over ten years and the other with a similar loan on a floating interest rate over the same period, may agree to take over each other’s obligations, so that the first pays the floating rate and the second the fixed rate.
• An option is a contract that gives the buyer the right, but not the obligation, to sell or buy a particular asset at a particular price, on or before a specified date.
• An over-the-counter is a derivative that is not traded on an exchange but is purchased from, say, an investment BANK.
• Exotics are derivatives that are complex or are available in emerging economies.
• Plain-vanilla derivatives, in contrast to exotics, are typically exchange-traded, relate to developed economies and are comparatively uncomplicated.
A sudden fall in the value of a currency against other currencies. Strictly, devaluation refers only to sharp falls in a currency within a fixed EXCHANGE RATE system. Also it usually refers to a deliberate act of GOVERNMENT policy, although in recent years reluctant devaluers have blamed financial SPECULATION. Most studies of devaluation suggest that its beneficial effects on COMPETITIVENESS are only temporary; over time they are eroded by higher PRICES (see J-CURVE).
A euphemism for the world’s poor countries, also known, often optimistically, as emerging economies. Some four-fifths of the world’s 6 billion people already live in developing countries, many of them in abject POVERTY. Developing countries account for less than one-fifth of total world GDP.
Economists disagree about how likely--and how fast--developing countries are to become developed. NEO-CLASSICAL ECONOMICS predicts that poor countries will grow faster than richer ones. The reason is DIMINISHING RETURNS on CAPITAL. Since poor countries start with less capital, they should reap higher RETURNS than a richer country with more capital from each slice of new INVESTMENT. But this CATCH-UP EFFECT (or convergence) is not supported by the data. For one thing, there is, in fact, no such thing as a typical developing country. The official developing world includes the (sometimes) fast-growing Asian tigers and the poorest nations in Africa . Studies of the relationship between GROWTH and GDP per head in rich and poor countries found no evidence that poorer countries grew faster. Indeed, if anything, poorer countries have grown more slowly.
DEVELOPMENT ECONOMICS has argued that this is because poor countries have unique problems that require different policy solutions from those offered by conventional developed-world economics. But new ENDOGENOUS growth theory instead argues that there is conditional convergence. Hold constant such factors as a country’s fertility rate, its HUMAN CAPITAL and its GOVERNMENT policies (proxied by the share of current government spending in GDP), and poorer countries generally grow faster than richer ones. Since, in reality, other factors are not constant (not all countries have the same level of human capital or the same government policies), absolute convergence does not happen.
Government policies seem to be crucial. Countries with broadly free-market policies – in particular, FREE TRADE and the maintenance of secure PROPERTY RIGHTS--have raised their growth rates. (Although some economists argue that the Asian tigers are an exception to this free-market rule.) Open economies have grown much faster on average than closed economies. Higher PUBLIC SPENDING relative to GDP is usually associated with slower growth. Furthermore, high INFLATION is bad for growth and so is political instability. The poorest countries can indeed catch up. Their chances of doing so are maximised by policies that give a greater role to COMPETITION and incentives, at home and abroad.
Despite starting with a big disadvantage, there is evidence that some developing countries do not help themselves because they squander the resources they have. Institutions that produce effective governance of an economy are crucial. Those countries that use their resources well can grow quickly. Indeed, the world’s fastest-growing economies are a small subgroup of exceptional performers among the poor countries.
Spawned by the end of the colonial era in the 1950s and 1960s, a whole branch of economic theory grew up around the question of how to promote economic development in poor countries. The proposition on which development economics was built was that poor countries were intrinsically different from rich ones and so needed their own set of economic models. Some development economists argued, for instance, that the self-interested, rational individual (HOMO ECONOMICUS) did not exist in traditional tribal societies. They claimed that because many poor countries had large agricultural populations and were often dependent on a few COMMODITY EXPORTS for foreign exchange earnings, economic policies that suited rich countries would not work for them. With hindsight, much of this was misguided, and policies based on it had disastrous effects. Development economists believed that the state had to play a big role in fostering modernisation. Instead, the result was huge, inefficient bureaucracies riddled with CORRUPTION, massive BUDGET deficits and rampant INFLATION. During the 1990s, most governments of DEVELOPING COUNTRIES started to reverse these policies and undo the damage they had done by introducing policies based on similar economic models to those that had worked in rich countries. However, the sequencing of these new policies seemed to make a big difference to how well they worked. Doing the right things in the right order is crucial.
The more you have, the smaller is the extra benefit you get from having even more; also known as diseconomies of scale (see ECONOMIES OF SCALE). For instance, when workers have a lot of CAPITAL giving them a little more may not increase their PRODUCTIVITY anywhere near as much as would giving the same amount to workers who currently have little or no capital. This underpins the CATCH-UP EFFECT, whereby there is (supposedly) convergence between the rates of GROWTH of DEVELOPING COUNTRIES and developed ones. In the NEW ECONOMY, some economists argue, capital may not suffer from diminishing returns, or at least the amount of diminishing will be much smaller. There may even be ever increasing returns.
Taxes levied on the INCOME or wealth of an individual or company. Contrast with INDIRECT TAXATION. In much of the world, direct tax rates fell during the 1980s and 1990s, partly because some economists argued that high rates of tax on income discouraged people from working, and that high rates of tax on PROFIT encouraged companies to move to countries with lower rates. Furthermore, high rates of INCOME TAX were viewed as politically unpopular. Even so, although rates were cut, because both personal income and corporate profits grew steadily throughout this period the total amount collected via direct taxation continued to rise. Economists often disagree about which of direct taxes or indirect taxes are the least inefficient method of taxation.
The rate of INTEREST charged by a CENTRAL BANK when lending to other financial institutions. It also refers to a rate of interest used when calculating DISCOUNTED CASHFLOW.
How much less is a sum of MONEY due in the future worth today? The answer is found by discounting the future cashflow, using an INTEREST RATE that reflects the fact that money in future is worth less than money now, because money now could be invested and earn INTEREST, whereas future money cannot. FIRMS use discounted cashflow to judge whether an INVESTMENT project is worthwhile. The interest rate is a means of reflecting the OPPORTUNITY COST of tying up money in the investment project. To test whether an investment makes economic sense the INCOME must be discounted so that it can be measured against the costs. If the present value of the benefits exceeds the costs, the investment is a good one.
The part of a company’s PROFIT distributed to shareholders. Unlike INTEREST on DEBT, the payment of a dividend is not automatic. It is decided by the company’s managers, subject to the approval of the company’s owners (shareholders). However, when a company cuts its dividend, this usually triggers a sharp fall in its SHARE PRICE by more than would be appear to be justified by the reduced dividend. Economists theorise that this is because a dividend cut signals to shareholders that the company is in a bad way, with more bad news to follow.
Dumping
Selling something for less than the cost of producing it. This may be used by a DOMINANT FIRM to attack rivals, a strategy known to ANTITRUST authorities as PREDATORY PRICING. Participants in international trade are often accused of dumping by domestic FIRMS charging more than rival IMPORTS. Countries can slap duties on cheap imports that they judge are being dumped in their markets. Often this amounts to thinly disguised PROTECTIONISM against more efficient foreign firms.
In practice, genuine predatory pricing is rare – certainly much rarer than anti-dumping actions – because it relies on the unlikely ability of a single producer to dominate a world market. In any case, consumers gain from lower PRICES; so do companies that can buy their supplies more cheaply abroad.
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