The Economic Way of Thinking

Vermont Teachers Financial Literacy Summer Institute

August 2011

Art WoolfUniversity of Vermont

Vermont Council on Economic Educationawoolf@uvm.edu

Plan

9:00-10:00 Introduction to Economics10:00-10:10 Break10:10-11:00 Trade, the standard of living,

and saving: a simulation 11:00-11:10 Break11:10 – 12:00 Applying economic concepts

to the world: The housing and financial crisis

Defining Economics

Defining EconomicsWhat is Economics About?• Way of explaining human

behavior• Common sense• Way of looking at the

world• Terminology and jargon

What is Economics Not About?• Making money• Business• Greed

Why Should We Be Interested in Economics?

How Well Has Humanity Done?

200,000 Years Ago

Life 200,000 Years Ago

How did people save?

Agriculture 20,000 Years AgoWhat were the consequences of not saving?

How did people save?

Harvesting Wheat 1500What were the consequences of not saving?

How did people save?

Peter Breughel the Elder, Wheat Harvest, Metropolitan Museum of Art

Harvesting Wheat 1860

Jean Millet, The Gleaners

Harvesting Wheat in U.S. 2010

Rice Harvest in India 2010

1880What were the consequences for the winter of not saving during the Montana summer?

CommodityTime-to-Earn

in 1895 (Hours)

Time-to-Earn in

1997 (Hours)

Productivity Multiple

Horatio Alger books (6 vols.) 21 0.6 35.0

One-speed bicycle 260 7.2 36.1

Cushioned office chair 24 2.0 12.0

100-piece stoneware dinner set 44 3.6 12.2

Hair brush 16 2.0 8.0

Cane rocking chair 8 1.6 5.0

Solid gold locket 28 6.0 4.7

Encyclopedia Britannica 140 33.8 4.1

Steinway piano 2,400 1,108 2.2

Sterling silver teaspoon 26 34.0 0.8

Things Are Cheaper Today Than 100 Years Ago

How About Today vs 1975?

Prices adjusted for inflation and in hours of work required at avg wage

1975 2010Dozen eggs $3.19 (0.16 work hours) $1.58 (0.08 hours)

Gallon milk $6.50 (0.32 hours) $3.62 (0.19 hours)

Pound of ground beef $3.38 (0.20 hours) $2.77 (0.15 hours)

Whole chicken/lb $3.35 (0.18 hours) $1.31 (0.07 hours)

Butter/lb $4.54 (0.24 hours) $3.61 (0.19 hours)

Tomatoes/lb $1.67 (0.10 hours) $1.92 (0.10 hours)

7.5 oz toothpaste $4.42 (0.17 hours) $2.19 (0.12 hours)

Morning Coffee

$151.03 7.5 hours$23.60 1.2 hours (12 cup)

Expensive TV

$3,103.97 154 hours $239 12.6 hours

32” HD LCD 720p

Clock Radio

$246.27 12.2 hours $11.00 35 minutes

$1,054.73 57.3 hours $999 52.6 hours

MacBook Air

$860 42.7 hours $207 7.9 hours

Steel Belted Radial

$168.66 8.4 hours $78 4 hours

Bridgestone PotenzaP195/60R-15

Microwave

$1,820.93 90.3 hours $58 3.1 hours

$2,814 139.6 hours $1,124 59.2 hours

Sears Best Home Depot 25 cu ft

9 Principles of Economic Reasoning

1. Due to scarcity, people have to make choices

2. Choices involve tradeoffs and costs• Opportunity costs• To Choose is to refuse

3. People make decisions by looking at expected costs and expected benefits

• What is the cost of saving?• What is the benefit of saving?• Where to save?• What investments to purchase?

Where to invest?

• Microsoft in 1986 cost 11 cents/share. Today it is $28: Turn $1,000 into $250,000

• On January 1, 2000 it was worth $500,000• Bear Stearns on March 12, 2008 cost

$61.58/share• On March 16 cost $2/share

Stocks or Bonds? Returns on $100 Invested in 1928

When and how much to save:Saving and compounding at 6.5% return/year

Saves Years At age 65 has

Maria $2,000/year Age 22-31 $273,000

Tom $2,000/year Age 32-51 $205,000

Sally $2,000/year Age 22-65 $520,000

Juan 10% of income Age 22-65 $940,000

4. People respond to incentives (such as prices) in predictable ways

5. The consequences of decisions are often in the future

• 1 in five Social Security recipients have no other source of income

• 1 in three Social Security recipients rely on SS for 90% of their retirement income

• The average monthly Social Security check is $1,200

http://research.stlouisfed.org/fred2/graph/?s[1][id]=PSAVERT

Americans’ Dismal Saving:Saving as Percent of Disposable Income

6. Voluntary trade makes people better off and creates wealth

7. Markets are a good way to organize economic activity and increase individual freedom

8. People create economic systems and institutions that influence their choices and outcomes

Starting a Small BusinessCountry Time Required Percent of per

capita income needed

United States 6 days 1.4%

Brazil 120 days 7.3%

Congo 84 days 735%

Haiti 105 days 212%

Source: World Bank http://www.doingbusiness.org/data/exploretopics/starting-a-business

9. The standard of living of a nation and its citizens is based on their ability to produce goods and services.

Same person, different income

Thinking about how an economy works: I was in discussion with a senior Russian official

whose job it was to direct the production of bread in St. Petersburg. “Please understand that we are keen to move towards a market system,” he told me. “But we need to understand the fundamental details of how such a system works. Tell me, for example, who is in charge of the supply of bread to the population of London?”

There is nothing naive about his question, because the answer, nobody is in charge, is astonishingly hard to believe. Only in the industrialized West, have we forgotten just how strange it is.

--Paul Seabright, The Company of Strangers

Fun, and Interesting, Books About Economics

• Charles Wheelan, Naked Economics: Undressing the Dismal Science

• Tim Harford: The Undercover Economist: Exposing Why the Rich are Rich, the Poor are Poor—and Why You can Never Buy a Decent Used Car

• Steven Landsburg, The Armchair Economist: Economics and Everyday Life

• P.J. O’Rourke, Eat the Rich: A Treatise on Economics• James Surowiecki, The Wisdom of Crowds: Why the Many are

Smarter than the Few and How Collective Wisdom Shapes Business, Economies, Societies, and Nations

• Russell Roberts, The Choice: A Fable of Free Trade and Protectionism

• Russell Roberts, The Price of Everything: A Parable of Possibility and Prosperity

Break time

Trade, Wealth, Income, and Savings: A Simulation

(hour 2)

http://www.bls.gov/emp/ep_chart_001.htm

Education and Income Worldwide

Spot the rich nations

http://apod.nasa.gov/apod/image/0011/earthlights2_dmsp_big.jpg

Break time

The Housing and Finance Crisis(hour 3)

Let’s Start a Bank

Bank Balance Sheet

Assets Liabilities$10 cash $90 Checking

acct$90 cash $10 equity

(capital)

And Make a Mortgage

Bank Balance Sheet

Assets Liabilities$10 cash $90 Checking

acct$90 mortgage (loan) $10 equity

(capital)

Background to the crisis• Politicians: How to increase homeownership

rate?• Regulators: How to set international risk-based

capital requirements?• Individuals: How to increase standard of living?• Financial organizations: How to innovate to

increase profits?• International Investors: Where to put savings?

Why are Low Down Payments Important?

• Suppose a house costs $200,000• Down payment of 3% = $6,000• Assume house prices rise by 20%/year• After 1 year, house is worth $240,000• The $6,000 investment has increased to

$40,000; a return of over 500%

Why are low interest rates important to homebuyers? A $425,000 mortgage

• Standard Fixed Rate Mortgage: $2,150/month• Standard Adjustable Rate Mortgage (ARM)

$2,100/month• Interest Only ARM (pay no principle)

$1,800/month• Option ARM (pay less than necessary) $1,250

– Note this is cheaper than renting– Note that monthly payment goes up a lot after 1 year

• This is the average price in Washington DC in 2005. It appreciated by 24% from 2005 to 2006

Factors leading up to crisis:

• Home ownership encouraged by– Federal policies– Low interest rates– Securitization of mortgages– Excessive use of leverage

• Risk and insurance was underpriced• This led to increased demand for housing

– A housing bubble developed

Where did the money come from? (I)

Listen to Giant Pool of Money on This American

Where did the money come from? II

What is Securitization?

The Extent of Securitization

Factors (continued)

• When housing prices kept rising, this was not a problem

• 2006 housing prices peaked• Underlying paper (mortages and mortgage

backed securities) fall in price• Institutions holding paper have losses on

balance sheet (asset values fall)• How do financial institutions shore up

balance sheets?

Housing Prices Rise…

…And get way out of line

And then collapse

Causing problems for owners and banks

23% of Homeowners are Underwater

The Debt Ceiling Problem

Revenues (2,230 b) Spending ($3,708 b)$0

$500

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

Everything else $913 b

Defense $462 b

Mandatory (SS, Medicare, Medicaid) $2,108 b

Interest on debt $225 b

Resources

• www.stockmarketgame.org– The stock market game

• www.investwrite.info– Writing component of stock market game

• www.councilforeconed.org– Resources for teachers on economics and

personal finance