What True Leaders MUST Understand about Economics

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1 Page 1 What True Leaders MUST Understand about Economics Dennis Roedemeier, CEO of Missouri Research Corporation on the campus of Southeast Missouri State University, recognized that there was a need for this basic information. He has spent his long career wearing a variety of hats: as an entrepreneur, a manufacturing manager, an economic developer, a state government division head and now running a university-affiliated research corporation. He has worked directly with two Missouri governors and has gained broad perspective from his vast and varied experience. As he readies to retire, he is inspired to leave some helpful tools for those who serve the public good. Roedemeier initiated this discussion with Dr. Bruce Domazlicky, Director of the Center for Economic and Business Research and Professor of Economics at Southeast Missouri State University in order to extract some beneficial information. The following brief discussion with Dr. Domazlicky is a straightforward set of questions about issues involving economics. Roedemeier asked Dr. Domazlicky to set forth the simplest doctrinal understanding that all of us must know, especially those of us who promote ourselves as local, state, and national leaders. This is part one of a four-part series filled with information to help those in charge make informed decisions that positively impact the lives of those who pay their salaries. You are about to start thinking like an economist. Introduction November 17, 2008 We traveled last week to St. Petersburg, Florida to a conference of university economic developers. When the discussion led us to the question of who understood basic economics, it didn t take long for all of us to agree that many of us had lost our technical edge. When asked who was interested in receiving a copy of this unpublished document on basic economics, nearly every hand in the room quickly shot up. Even the self-proclaimed experts need a dose of Basic Economics. Mark Twain once commented, It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. So it is often with all of us in economic development, and on city councils, county courts, and in state and federal leadership. It is what

2 Page 2 we think we know or should know that we really do not know that ends up hurting us and casting a pall of personal irrelevance on our efforts. People who count on our judgment often do not realize until it is too late that they have misplaced their trust in our presumed expertise. DR: So why should someone care about understanding economics and what possible value is it to the average businessperson or government leader? BD: Economics is all about making decisions when resources (land, labor and capital goods) are scarce; which means just about every decision that has to be made. Knowledge of economics can help an individual to systematically approach decisions and search for the best answer or solution. The economist s approach focuses on benefits and costs. That is, for example, if you are trying to decide whether to add one more police officer to your force, you need to look at the additional costs (the officer s salaries and benefits and any additional equipment such as a patrol car, etc.) and compare these costs to the additional benefits (reduced crime, more crimes solved, etc.). I know this seems to be a very straightforward approach, and it is but it is also the first step in learning how to think like an economist. DR: Why are economists so lousy at forecasting?

3 Page 3 BD: I admit that economists do not necessarily have the best forecasting record. But in their defense, it is difficult to forecast where a $14 trillion economy might be headed. Our large economy is a result of the decisions of over 300 million people, so it is no wonder that economists are not always very accurate, but that doesn t seem to stop them from trying. DR: What is your favorite forecasting tool? The most publicized economic forecasting technique is also one of the simplest: the Index of Leading Economic Indicators. A study of past recessions and boom times has allowed economists to identify certain economic variables as Leading Indicators; these are variables that tend to decline before the rest of the economy does in a recession and to start to recover before the recession has ended. This makes them particularly useful as forecasting tools. There are ten variables that are combined into an index to give us the Index of Leading Indicators. (Some of the variables include the money supply, stock prices, building permits, average weekly manufacturing hours, average weekly initial claims for unemployment insurance). This Index is typically widely reported in the media. Economists also have more sophisticated methods and models that they use that gives more detailed forecasts on such things as Gross Domestic Product (production of goods and services),

4 Page 4 unemployment rate, inflation rate, etc. The Federal Reserve Bank of Philadelphia issues a quarterly report that summarizes the forecasts of professional economists. The report is useful for getting a sense of what economists are thinking about the performance of the economy. DR: Are these forecasts really of importance to the local business person or city manager? BD: Absolutely! Whether one is in business or in public service, planning is essential. Annual budgets have to be devised, decisions on new capital projects have to be taken, and labor force needs have to be assessed. In this context, information about the near-term performance of the economy (6-12 months) can be very useful. Of course, given the sometimes spotty record of economists in forecasting, it is best to look on these as one source of information and not necessarily the last word on what will happen in the coming year. But clearly, an anticipated slowdown in the economy will affect most governments as retail sales revenues are likely to grow more slowly. Businesses may find it advantageous to postpone major capital projects for a few months until economic uncertainty diminishes. But perhaps the main point is that planning is always necessary and the more information one can plug into the planning process, the more likely the plan is to be realized.

5 Page 5 Dennis Roedemeier and Dr. Domazlicky meet with Ken Eftink, City Manager of Cape Girardeau, Missouri DR: Dr. Domazlicky, if I had two piles the smart pile and the dumb pile for politicians, what would you put on the top of the dumb pile? BD: Politicians when running for office, particularly state and local offices, seem to have the same mantra: jobs, jobs and more jobs. It is difficult to find a politician who says they will not bring any new jobs to a region. Yet if you look at unemployment figures, what you see is that the higher the education levels of a group of folks, the lower its unemployment rate.

6 Page 6 So if you want to lower the unemployment rate for a region, it would seem that the best way might be to raise the average education level of the region s populace. In fact, one persistent component of the unemployment rate is structural unemployment. Structural unemployment occurs when the individuals who are unemployed do not have the proper skill, education, and training to qualify for the jobs that are available. It is estimated that structural unemployment can be as high as two to three percentage points of the total unemployment rate at any given time. There is clearly more to it than just getting people to stay in school longer; however, it is difficult to find an unemployed physician, for example. That said, there still is a need to be sure that if people do receive more education that there will be jobs available for them. This may be particularly true at the regional level since people are quite mobile and will move if they cannot find acceptable employment. This also touches upon a lasting concern in economic development theory. Do we concentrate on places or people? That is, do we concentrate our efforts on attracting jobs to a region or do we put our effort into improving the education and skill levels of our populace? It is easy to answer: both! But the reality is that economic development dollars are scarce and it is not always feasible to do both. If a region concentrates on improving the

7 Page 7 employability of its residents, it will have to be aware that there is a chance that some of them will move away when their education or skill levels are higher. However, it is also clear that improvements in a region s labor force will make it more attractive as a location for new firms, so to an extent, concentrating on people can also lead to improvements in the economy of a region. DR: Dr. Domazlicky, we hear a lot about waste and inefficiency. Can you talk about how efficiency applies to basic economics? BD: Efficiency is a word that gets tossed around a lot, but Technical efficiency means getting the most output out of a given amount of inputs few people probably know the real meaning of the word. Technical efficiency is likely what most people think of when hearing the word efficiency. or equivalently, producing a given level of output with the fewest possible inputs. In a world of scarce resources (scarce labor, capital goods, and scarce natural resources, scarce entrepreneurs), it is easy to see why we want to strive to be efficient. The more output we can squeeze out of our limited resources, the better off we will be. A popular measure of efficiency is to look at labor productivity. The simplest measure of labor productivity is just total output divided by the number of workers. We can measure this for the

8 Page 8 whole economy, a particular industry (such as the automobile industry) or for a single product (baked bread). Our country s per capita income (total income divided by our population) is dependent upon labor productivity. As the amount of output per Our country s per capita income (total income divided by our population) is dependent upon labor productivity worker increases, the more each worker can be paid without having to raise prices. Suppose that we consider the production of an automobile and assume that labor is 50% of the cost of producing that automobile. If workers are granted a 5% pay raise for the year, but their productivity is unchanged, then the costs of the automobile manufacturer will have risen by 2.5% (50% times 5%). We can be sure that this will translate into an increase in the price of the automobiles that are being produced of something close to 2.5%. But suppose the labor productivity of the workers increases by 5% in a given year; that is, the same number of worker working the same number of hours produce 5% more cars. Now if we raise their wages by 5%, Labor productivity is just total output divided by the number of workers the automobile manufacturer s costs per car are unchanged. So there is no pressure to raise prices. This simple example illustrates the importance to our economy of improvements in efficiency that lead to higher labor productivity. In fact, in a mature economy such as ours, most of the

9 Page 9 improvements in our standard of living are going to come from increases in our labor productivity.