The Other McCain

"One should either write ruthlessly what one believes to be the truth, or else shut up." — Arthur Koestler

Economics for 11-Year-Olds

Posted on | October 8, 2010 | 17 Comments

Thursday, after I picked up my kids from school, we were listening to the news on the car radio and something prompted my 11-year-old son Jefferson to ask, “Dad, what’s a recession?”

So I explained that the official designation of recession is two consecutive quarters of negative economic growth — a decline in the gross domestic product.

Next, Jefferson asked, “What’s a double-dip recession?”

That’s when the economy goes into recession, then briefly returns to positive economic growth, before turning downward again. I talked about the double-dip of 1981-82, explaining that the second half of that double-dip was caused by the Federal Reserve tightening the money supply to eliminate the inflation that had plagued the U.S. economy for a decade. That sharp recession, however, was followed by one of the strongest sustained recoveries in history.

I then explained my belief that the U.S. economy is headed into — if indeed we have not already entered — the second half of a double-dip, mainly because of continued fallout from the mortgage meltdown.

There was a news item about the foreclosure crisis: Banks unable to re-sell foreclosed homes because of flawed paperwork.

This, I told Jefferson, was a disaster. Not only would the banks be prevented from recouping the value of these homes, but this would prevent the “market clearing” function necessary to establish accurate pricing in the housing market.

Prices are information. We are used to going into a store, picking up an item and paying the marked price without thinking much about it — $1.19 for a 16-ounce Coke or something. We can shop around for sale prices, but in most cases, we just go to the store and pay whatever price is asked.

This fixed-price system, however, does not apply to big-ticket items. The price of a major purchase like a house or a car is almost always a product of negotiation. If the “sticker price” on a car is $30,000, the customer who has ready money (either cash or solid credit) will offer to pay $25,000. The dealer will counter-offer — say, $27,500 — and this negotiation process will continue until either a price is agreed on or the customer decides he will seek a better deal elsewhere.

The negotiability of price is especially applicable to home sales, as a home is usually the largest purchase any of us will make in our lifetimes, and so every home buyer tries to get the best possible bargain. This, I explained to my 11-year-old son, is why the freezing of foreclosures is such an economic disaster.

You don’t know what something is worth until you sell it. You may think your house is worth $200,000, but if you can’t find a buyer willing to pay that price, it’s not worth it.

The value of any home is determined by comparison to the price paid for nearby homes of similar quality. If you put your house on the market for $200,000 and, the next week, a similar house in your neighborhood sells for $150,000, this is a signal to you (and to any prospective buyer) that your asking price is too high.

By impeding re-sale of foreclosed homes, then, the current problem — “foreclosure chaos,” as the Washington Post calls it — is preventing the only possible way to establish accurate market prices, and thus discouraging all home sales.

In many neighborhoods, there are multiple vacant homes, with houses either for already up for sale or awaiting the conclusion of foreclosure proceedings. Buyers in such a market will be hesitant to close a deal because of the possibility that, the day after they pay $150,000 for their home, a similar house down the street will sell for $120,000. And so long as buyers have such strong incentives against buying, lagging demand will result in further declines in prices.

Well, we were home by the time I got that far into the discussion, so I didn’t get to explain why all the government’s efforts to “help” homeowners who can’t afford their mortgage payments have actually hurt the economy. Maybe I’ll explain that this afternoon.

If I believe my 11-year-old can understand basic economics, why don’t our politicians think voters can understand?


17 Responses to “Economics for 11-Year-Olds”

  1. Unseen
    October 8th, 2010 @ 3:31 pm

    Maybe but deflation also allows more people to enter the market increasing demand and allowing more supply to come into the system. Deflation is not to be4 feared but embraced.