How to Follow Economics

Imagine for a moment that you work at a lemonade stand. If you’re currently making $10 per hour — which is the price of your labor or time — and then you hear of an opportunity a few miles further for $15 per hour, you consider switching jobs. Being a rational person, you calculate whether that $5 per hour increase is worth the price of a farther commute, which comprises extra gas and time. Your calculations represent economics at its simplest. 

You probably recognize that economic insights cut across many domains of the human experience, such as psychology, finance, politics, beauty, and justice. But economics, which tends to come to us in bursts of jargon and math and partisan commentary, is often confusing for the average person. 

All you need to understand is one thing: prices. Prices are not only the cost of a banana or a gallon of gas or a house. Interest rates are also a price (of money), as are wages (the price of labor), minutes (the price of time), and physical exertion (the price of energy or health). Profits are also prices that incentivize behavior individually and corporately. 

A price acts as a signal that incentivizes behavior. That signal coordinates individual behavior as well as societal behavior. And the considerations involved between a $10-an-hour job versus a $15-an-hour job farther away are the same on a larger scale, such as for entrepreneurs and policymakers. 

The interesting thing is that no one tells these people what to do except a number. Enter, Adam Smith’s idea of an invisible hand guiding society. That’s what economists mean by describing humans as “self-interested” “rational animals,” or Homo economicus: We all make decisions based on economic calculations constantly in almost every area of our lives. These decisions happen for you hundreds or thousands of times a day. Add them all up, multiply by everyone in society, and you get billions of decisions, transactions, and incentives every day across many markets that make up an entire economy. And it’s all based on prices.

Understanding this phenomenon helps you cut through the jargon and spin in economics news. A few numbers are more important to know than others. 

Interest rates are a leading example. The Federal Reserve, America’s central bank, sets interest rates to control inflation. If interest rates, which is a price for money, increase, then demand decreases, theoretically cooling the overall economy and thereby decreasing inflation. Higher inflation requires higher rates, which lowers employment due to less activity in the economy. That’s why the employment rate is a related number.

Other important signals include the prices of a barrel of oil, a stock market index like the S&P 500, gold, U.S. Treasuries, rent, corporate tax rates, and even the price of a dollar itself. Each of these macroeconomic data points tells economists, financiers, and business people what’s happening in the economy, much like an instrument dashboard in your car. That’s why the top of the front page of The Wall Street Journal displays some of these key figures. You can find other dashboards at sites like tradingeconomics.com.

Microeconomic data is harder to come by, but it’s equally important.

Why do news outlets seem so skewed about what’s happening in the world? Precisely because prices incentivize behavior one way or another, and each side of the political aisle picks their preferred side of the story. The debates around minimum wage is the classic story that mushes together macro- and microeconomics as well the political left and right. 

Consider the lemonade stand, but this time you’re the owner. Imagine you have three employees who work for your lemonade stand, all earning $10 per hour. In addition to your costs for sugar, water, and cups, your labor costs are half your total expenses. Now imagine that a law passes where the federal minimum wage is increased to $15 per hour.

The political left — typified debatably by The New York Times, MSNBC, or CNN — argues increased income for those employees allows them better to put food on their tables and send their kids to college. That’s the microeconomic basis. On the macroeconomic basis, increased incomes lead to increased tax revenue, which over time improves schools, social benefits, and infrastructure. 

But in reality your labor costs increased by 50 percent, aside from other taxes and benefits, which means your overall expenses increased by more than 25 percent. That means, as a lemonade stand owner, your profit  — your income — was dramatically reduced. You, too, have to put food on the table and send your kids to college. The political left’s story says that greedy corporations and executives won’t let go of their profits to help the average person flourish. Yet if 88 percent of the 28 million businesses in America employ fewer than 20 people, who exactly is the average person?

Now you have to do one of two things to make up the difference: Either increase your revenue by passing on the increased costs to your customers, making them worse off, or reduce your expenses by laying off an employee, making them worse off. Of course, you could reduce your income — a third option that makes you worse off. 

That’s why the political right — typified debatably by The Wall Street Journal, the Economist, and Fox News — argues that increasing the minimum wage (or taxes, or energy costs, or many other prices) will in reality reduce jobs over time through shutdowns or layoffs or it will lead to inflation or it will lead to a less competitive American economy, since foreign labor will do the same job for a much lower price. 

Both sides have ample theories and data to support their arguments. Whom should you believe?

As is often the case, theory and reality don’t always match up. The map is not the territory. Your best judge of what will happen in the economy is yourself. If you believe that everyone is born with God-given reason as a human being created in the image of God, then you may be able to extrapolate your resulting behavior to others. Just remember, in the words of famed investor Charlie Munger, to never underestimate the power of incentives.