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Factors of Production

Land, labour, capital, and enterprise…a powerful mother; the perfect storm necessary for economic activity.

Fair Tax

A single national retail sales tax; a popular alternative to the current federal tax system: a 67,000 page tax code enforced by the Internal Revenue Service (IRS). The IRS is an arm of the Treasury, which requires citizens to be taxed, to staff an operation, that collects taxes from us.

A fair tax, like any other retail tax (for example: gasoline taxes), is collected by the business and transferred to the government. According to GPOaccess.gov, the discretionary spending budget for the Treasury is scheduled at $12.7 billion for 2009 and $13.3 billion for 2010. The IRS, for fiscal year 2009, will take up $11.362 billion of the Treasury budget.

The IRS makes great “returns” for their law enforcement auditing activities, to the tune of about $7 collected to every dollar spent. In 2009, $7.5 billion will be appropriated specifically for collecting “tax gap” revenues. In the grand scheme of an $11.4 trillion public debt, a few billion is chump change. But, proponents of the fair tax argue that it would be far less costly to collect from businesses, and thus, fewer agents of taxation. It would seem logical that taxing general consumption of everyone in the country would result in greater tax revenues for the government. Currently, about 33% of the country pays zero federal taxes. And then there is the issue of illegal immigrants. The Heritage Foundation’s Robert Rector published a study that the average illegal immigrant family receives an average of $30,000 annually in government benefits, like welfare and Medicaid. Illegal immigrants pay only about $9,000 in taxes per year, or a $21,000 shortfall that the American taxpayer has to make up. To be fair, the average illegal immigrant family tends to receive fewer benefits than other American households, but still leaves a significant tab for legal citizens. Given that budget deficits are already projected in 46 states for fiscal year 2009, with initial estimates of these shortfalls totaling $133 billion, the United States is broke. We no longer can consider expenditures “chump change.” As the full extent of 2010 deficits become known, shortfalls are likely to equal $145 billion.

Still, some critics of the fair tax argue it would produce fewer tax revenues. The fair tax would be progressive on consumption. That is, the more a person consumes, the more they will pay in taxes. This isn’t quite like the current progressive tax on income, where the more a person earns, the greater percentage of their income they must ante up. But, wealthier people tend to consume more than others, last time I checked. Most Americans spend between 96-103% of their income.

Consider a person who makes $250,000/year. After paying 8% of it in state taxes, they’re left with $230,000. Let’s say they live in a nice 3,000 sq. ft. home and pay $5,000/month for housing costs and amenities, or $60,000/year. That leaves $170,000 for personal, retail consumption. So they purchase a green car on the “cash for clunkers” program for $30,000 and spend $25,000 for food, $20,000 for entertainment and $25,000 on car and medical insurance expenses; all of which are personal consumption. Over the course of the year, this person spent $105,000 on personal expenditures, all of which could be taxed under a fair tax plan. If the fair tax was 30%, they would have a federal tax burden of $31,500. Not only that, but this individual would have managed to save $38,500, or 15.4% of their income! This person would be considered fairly affluent by most standards, and clearly lives a respectable lifestyle.

The last scenario seems healthy to me, but the collected tax revenue from that one individual is less than the current system lawfully is able to swipe. If that person has an adjusted gross income (AGI) of $225,000, they would be in the 33% federal tax bracket, and owe $74,250 to the IRS.

Would collecting consumption taxes from people who don’t pay their full tax burden, the 33% of Americans who don’t pay federal taxes at all and illegal immigrants, make up for the gap in lost taxes collected from our hypothetical “rich” person above? That’s the crux of the debate. It doesn’t seem to me that revenues would suffer much, if at all, under a fair tax. With competitive tax rates, the United States would attract more international business, which would increase economic growth and thus, tax revenues.

Notably, economic liberties would improve under a fair tax.

Fair Trade

Chris Martin wants to “Make Trade Fair” as evidenced at Coldplay shows. Trade isn’t always fair but neither is life. Debating fairness is a lot like debating whether or not Hilary Swank is hot. What makes something fair really depends on who you ask. Free trade tends to be beneficial because countries have comparative and absolute advantages in producing certain products and services. Every country specializes in what they do best and swap. This way everyone in the global community gets what they want in an efficient manner.

Fannie Mae

Officially known as the Federal National Mortgage Association (FNMA); nicknamed Fannie Mae. Like Freddie Mac, Fannie started as a government sponsored entity (GSE), but morphed into a public company over time, with stockholders and heavy involvement from politicians; a quasi-private institution. The organization’s primary purpose is to buy and securitize mortgages, and to free up as much capital for Federal housing loans as humanly possible. In economics speak, it is to expand the secondary mortgage market.

Founded in 1938 during the Great Depression, and chartered by Congress in 1968, Fannie began pumping considerable funds into the housing market around the same time the U.S. dollar was no longer pegged to gold. In 1971, the Bretton Woods monetary system collapsed, and the rest of the world pegged to the U.S. dollar. America vowed never to inflate its currency. Of course, that hasn’t proven to be the case:

Increasing the monetary base, and thus the money supply even more due to fractional reserve banking, devalues a currency by causing inflation.

This new era of floating exchange rates, along with forces like Fannie Mae, spurred an allocation of resources in an unhealthy and undeliverable way. How so? We’re now experiencing a housing recession brought on by an overbuying and overbuilding phase; the financial sector is a mess largely due to the secondary mortgage market pooling and selling of these assets; and what would be the worse calamity of all, in which the jury is still out: the collapse of the dollar from over-inflating monetary policy and other countries dumping their increasingly less valuable dollar reserves onto the market.

The U.S.’s mortgage market reached $12 trillion as of 2008. Fannie Mae and Freddie Mac owned or guaranteed about half of it. One might say they were a major player.

Federal Funds Rate

The interest rate banks charge one another for loans. By targeting this rate, the Federal Reserve can influence the money supply, and the value of money. The Federal Open Market Committee meets eight times a year to determine the rate, unless global financial crises are occurring, where they will meet more often.

Federal Reserve

There is nothing Federal about the Federal Reserve. It’s as Federal as Federal Express. A non-government entity, the Federal Reserve is a bank that uses monetary policy to influence long-run interest rates. Your savings account interest rates as well as loan rates go up and down as a result of the Fed’s actions.

The Fed can’t change short-run rates, the free market deals with those. They set targets for long-run rates and try to get as close to the target as possible. In real time rates constantly fluctuate. When the fed chair announces a quarter point interest rate cut you’re dealing with the Federal Reserve Bank.

They can’t wave a magic wand or erase an interest rate with a number two pencil. The main tools at the Fed’s disposal are the buying and selling of securities and the Treasury’s printing press. The Fed manipulates the money supply by either buying securities like a Treasury bond and injecting money into circulation, or selling securities they already own to take money out of circulation. If you believe Milton Friedman inflation is strictly a monetary phenomenon. This means the Federal Reserve has power over inflation through manipulating the money supply…bone-chillingly powerful. The Fed works closely with the Treasury who owns the printing presses creating new dough. If large amounts of new cash are being injected into circulation, the Treasury prints entirely new money for the Fed. Every time a new dollar is printed, the dollars already in your paycheck, bank accounts, and retirement are automatically worth less. They don’t check with citizens before they devalue your money.

The role of the Fed is expanding. The Fed now makes direct loans to private industry in addition to depository institutions. The Fed bank has gone national!

Federal Reserve Chair

A position confirmed by the Senate in 4-year terms, the Federal Reserve Chair presides over the Federal Reserve Bank’s open market operations and other policy decisions. A powerful position largely influencing money supply and inflation, investors often wait eagerly to hear every word of every statement coming from the Fed Chair. Investors will dissect the statements and piece it back together like a puzzle to predict future policy decision and assess confidence levels within the economy.

Federal Reserve Banks

Twelve Federal Reserve Banks exist across the United States in twelve Federal Reserve districts. Operating within the twelve regional banks are twenty-five branches spread across the country. The Federal Reserve banking system was created by Congress to hold reserves for regular banks and loan money to them. Other important features include taking part in monetary policy decisions with the Fed Chair and regulating commercial banks in their district for safety and soundness. Well, those commercial banks in the “federal reserve system.” Chances are if a bank is small and doesn’t borrow money from their Federal Reserve Bank, they shouldn’t have much trouble. Large participating banks don’t wake up to a lot of scrutiny either as many banks stationed in New York ran wild to their collapse in 2008. Who was the chair of the New York Federal Reserve during this time? Timothy Geithner, confirmed as Secretary of the Treasury in the beginning of President Obama’s administration.

Fiat Currency

A currency that is “declared” legal tender by some government body, deemed to be acceptable for paying all taxes and debts. The U.S. dollar is a fiat currency. Because it is the world’s most widely-held reserve currency, the world community gets upset when U.S. policy makers devalue the dollar at will. The Federal Reserve controls the money supply, the Treasury can add to the money supply and the current administration can run up debts that all affect the value of the U.S. dollar.

Fine Tuning

The belief held by Keynesian economists and Federal Reserve fans that the economy can be managed through monetary and fiscal policy to control demand and keep the economy steadily growing. In order for man to soften man’s business cycles, man must make accurate predictions about what the economy will face. Economists are rarely accurate. Fine tuning was an attempt to play God with the economy but poor forecasting actually made cycles more volatile.

First-Mover Advantage

Last one there’s a rotten egg. Another classic game theoretical principle, the first one to enter a market (or create one) gets the gold star. This firm will have an advantage of setting up barriers for potential competition, build brand equity and customer loyalty, and ultimately scare people from attempting to compete. Bill Gates mastered this technique when setting up Microsoft Windows as the exclusive operating system for IBM. He identified a market IBM couldn’t see under their noses and predicted the precipitous rise in personal home computing.

Despite a worthy competitor in Apple, Windows still dominates the operating system marketplace with both business and personal computers despite having what some consider an inferior product.

Fiscal Policy

Includes government spending and tax policy. The basic goal is to control demand by keeping unemployment as low as possible and curbing inflation.

Fixed Costs

Costs that do not change regardless of how much you show up, how your business performs, or how much you produce. Fixed costs are really only adjustable in the long-run (defined as over a year but in this case probably much longer). A typical example would be the cost of leasing out a space. A business is on the hook for the duration of the lease contract and will not be able to adjust those costs until the contract expires and the business can retool.

Forecasting

A drunk person has a better chance of operating a motor vehicle home than an economist does forecasting something correctly. The more specific the forecast, the more hopeless it is, ceteris peribus.

Foreign Direct Investment

When a domestic firm sets up operations in another country. This could be through the purchase of an existing business abroad or using foreign land and labour to extend domestic operations. This is like Nike setting up shop in Indonesia. FDI has contributed mightily to globalization and is a strong example of firms seeking the lowest possible land and labour costs available. In a world with an extensive and efficient supply chain, it really doesn’t matter where products are made.

Foreign Exchange

The FOREX market serves as an international exchange for world currencies. Currencies are valued in comparison to other currencies. For example, it may take $1.53 to buy €1.00 (euro). After the gold standard era (all paper currency had physical gold backing it locked up in places like Fort Knox), most currencies were pegged to the dollar. This amounts to keeping the spread between currencies equal based on the movement of the dollar. When currencies float (no longer pegged to anything), they are completely at the whim of the FOREX market. Currency traders consider each country’s monetary policy with respect to one another in their investment decisions. It’s all relative in economics.

Fractional Reserve Banking System

Contemporary global banking, fractional reserve system’s keep only a fraction of demand deposits on hand. Banks have reserve requirements. In the case of the U.S. banking system, a bank must hold 10% of their total cash pool in reserve. The remaining 90% can be used for new credit creation.

Keep in mind that over 95% of the total money supply is electronic; numbers dancing on computer screens. When a bank gives a car loan or a home equity line of credit, they are moving numbers around, not physical money. They’re allowed to move 90% of their total money pool around into new loan contracts for the public. So, if the Bank of Swift had $100 worth of deposits, it could give $90 of loans out. But the $90 doesn’t come out of the $100 of deposits. It gets created out of thin air and tacked on top of the original $100. Now, the money supply has increased $90. It’s easy to do when money is digital.

The Central Bank creates a certain amount of monetary base. Then the broad money supply is determined by a money multiplier, in addition to the original monetary base. The money multiplier is determined by the reserve requirement (a ratio, in the U.S.’ case: 10%). The multiplier effect, and thus the total money supply in circulation, is theoretically infinite. Because modern money is fiat currency, it isn’t backed by any physical asset such as gold. As a result, when the money supply increases, so does inflation, which erodes the purchasing power of money.

Freddie Mac

Officially known as the Federal Home Loan Mortgage Corporation (FHLMC); nicknamed Freddie Mac. Like Fannie Mae, Freddie started as a government sponsored entity (GSE), but morphed into a public company over time, with stockholders and heavy involvement from politicians; a quasi-private institution. The organization’s primary purpose is to buy and securitize mortgages, and to free up as much capital for Federal housing loans as humanly possible. In economics speak, it is to expand the secondary mortgage market.

Created in 1970, Freddie began pumping considerable funds into the housing market around the same time the U.S. dollar was no longer pegged to gold. In 1971, the Bretton Woods monetary system collapsed, and the rest of the world pegged to the U.S. dollar. America vowed never to inflate its currency. Of course, that hasn’t proven to be the case:

Increasing the monetary base, and thus the money supply even more due to fractional reserve banking, devalues a currency by causing inflation.

This new era of floating exchange rates, along with forces like Freddie Mac, spurred an allocation of resources in an unhealthy and undeliverable way. How so? We’re now experiencing a housing recession brought on by an overbuying and overbuilding phase; the financial sector is a mess largely due to the secondary mortgage market pooling and selling of these assets; and what would be the worse calamity of all, in which the jury is still out: the collapse of the dollar from over-inflating monetary policy and other countries dumping their increasingly less valuable dollar reserves onto the market.

The U.S.’s mortgage market reached $12 trillion as of 2008. Fannie Mae and Freddie Mac owned or guaranteed about half of it. One might say they were a major player.

Free Lunch

Between opportunity cost, shadow pricing, and externalities, everything has a cost. Feast on that.

Free Riding

Getting the benefits of a product or service without opening up your pocketbook. Bars will often serve popcorn, peanuts, or pretzels to its patrons for free. In this case, the bar isn’t attempting to charge for the snacks, but expects it to be a suitable compliment to a micro brew, which they will charge a premium for. If enough patrons hang out in the bar for snacks and never order a drink, eating up capacity, free riding could become an issue. That is, the benefit of those willing to pay for beer wouldn’t exceed the cost of providing free snacks and space for bar patrons.

Full Employment

You’re hired, if you want. This is where all who want a job have one, at the market wage. In a free capitalist society, an economy with everyone employed is impossible; just as an economy with universal health care will not mean everyone has health insurance. Frictional unemployment is impossible to avoid as well. This describes workers in transition moving from one job to another.

Fungible

The bank robber doesn’t mind what $100 bills you fill their burlap sack with, just get the thing filled and pronto. A fungible item is impossible to differentiate from its brethren. All forms of money must be fungible and equally qualified to “make it rain” with.