Macroeconomics "R" Us

What in the world does "macroeconomics" have to do with personal finance? Well, it turns out quite a bit. Many people believe we have no control over the big picture, just our response to it. But by understanding larger forces better, we can increase our control over the bits within our individual grasp.

What in the world does "macroeconomics" have to do with personal finance? Well, it turns out quite a bit. The main distinction for our purposes is that we, individually, have no control over the big picture, just our response to it. As Americans, we typically think of economics in terms of saving, earning and -- most of all -- spending. But by understanding larger forces better, we can increase our control over the bits in our individual grasp.

Let's look over some of the specifics. First, as we have learned in recent weeks with the euro melting down over the debt situation amongst what they call the "PIIGS" (Portugal, Ireland, Italy, Greece and Spain), you could argue that purely independent national economies, as we used to think of them, no longer exist. We have become that interdependent. That's a good thing if a nation has accelerated growth based upon rational, regulated, expanded markets. Not so good if it doesn’t.

Or look at how our excesses in the no-skin-in-the-mortgage game have sent financial tsunamis, not only through the rest of our economy but the rest of the world as well -- and many of us have yet to fully recover. Promoting private home ownership is a political principle that we have always assumed is a good idea. Get everyone to be a stakeholder in the economy, and all that.

Yet in Europe, there’s a more measured view based on past experience. In Germany, for example, 80 percent of the population rents. Obtaining a mortgage requires at least 50 percent down and solid credit to back it up. Short of a catastrophe, no mortgage meltdowns will happen in a society that saves 12 percent of their income. (Americans are lucky to save 1% to 2%.) Where European countries get into trouble is when they borrow for social-engineering purposes -- a painful lesson the U.S. is now learning, thanks to Medicare, Social Security and other entitlement programs.

We already know about inflation. How your dollar will buy less, how a fixed income will, on the one hand, condemn you to reduced purchasing power over time but, on the other, allow you to pay back debt at pennies on the dollar. Inflation is based upon rapidly rising demand — when supply can’t keep up, prices of goods and services are forced higher. The Federal Reserve, led by Ben Bernanke, watches their tea leaves and is quick to raise or lower interest rates to stimulate or dampen demand to manage inflation, which they do fairly well.

Deflation, which we have seen the last two years, is the opposite. People stop spending, either because they can’t afford it or because they’re waiting for prices to come down. But it is a self-serving fall off a cliff. The economy and jobs dry up as people put off spending, and consumers end up being able to spend even less because they’ve lost jobs due to the self-same decreased demand. It's a death spiral.

That's why the government has not only drastically reduced interest rates to stimulate economic activity, but has been spending hundreds of millions of dollars in an attempt to shore up the economy until the psychology changes. And make no mistake, psychology is a major player in macroeconomics. Just look at the volatility in the stock market. One overreaction after another, based upon the thinnest news and a herd mentality.

Let's look at exchange rates -- very important. A strong dollar means U.S. goods and services cost more overseas, so foreign countries buy less from us and that hurts our economy. When the dollar is weak, demand for U.S. goods and services rises and that stimulates our economy. That's why the Chinese have been reluctant for so long to allow the yuan to rise against other currencies, especially the dollar. (This week, however, the Chinese government has signaled that policy may be about to change.)

Artificially keeping your currency undervalued, as the Chinese have long done, pumps up an export-based economy and keeps growth and jobs going. This is especially true if you are not spending what you are earning and the government remains willing to accept payment in dollars, as the Chinese are doing. A problem may occur, however, if China allows its economy to cool down to help keep the U.S. economy stronger -- so Americans will keep buying Chinese goods and repaying our debts. A slowdown in the Chinese economy could lead to huge social unrest with high unemployment and the like.

What does this mean for the U.S.? More cheap goods for people who are hooked on spending. I know a family that is trying to live without buying anything made in China and they can't do it. We've become that interdependent.

So what does all of this mean in terms of how we individually save, earn, and spend?

Well, saving more is always good, for our kids' college, for our retirement, for our financial security, etc. Having our savings earn more is a good thing, too. Most of us, though, are not capable of earning consistently above-average returns, although some of us think we can. (And you know who you are.) So mostly we diversify our investments, in a bit of a defensive posture, including a small percentage set aside in foreign mutual funds.

The last area, spending, is the toughie. Guns and butter, ant versus grasshopper, etc. As a card-carrying American Consumer I am in no position to give anybody advice on this one -- you’re on your own to let your conscience be your guide. Heaven help us! The economists can't even explain the past let alone predict the future. Little help from them for now. Macroeconomics, hmmph. As is so often the case, we're back on our own.