The Economic Way of Thinking Vermont Teachers Financial Literacy Summer Institute August 2011 Art Woolf University of Vermont Vermont Council on Economic Education

Plan 9:00-10:00 Introduction to Economics 10:00-10:10 Break 10:10-11:00 Trade, the standard of living, and saving: a simulation 11:00-11:10 Break 11:10 – 12:00 Applying economic concepts to the world: The housing and financial crisis

Defining Economics

What is Economics About? Way of explaining human behavior Common sense Way of looking at the world Terminology and jargon What is Economics Not About? Making money Business Greed

Why Should We Be Interested in Economics?

How Well Has Humanity Done?

200,000 Years Ago

Life 200,000 Years Ago How did people save?

Agriculture 20,000 Years Ago What were the consequences of not saving? How did people save?

Harvesting Wheat 1500 What were the consequences of not saving? How did people save? Peter Breughel the Elder, Wheat Harvest, Metropolitan Museum of Art

Harvesting Wheat 1860 Jean Millet, The Gleaners

Harvesting Wheat in U.S. 2010

Rice Harvest in India 2010

1880 What were the consequences for the winter of not saving during the Montana summer?

Commodity Time-to-Earn in 1895 (Hours) Time-to- Earn in 1997 (Hours) Productivity Multiple Horatio Alger books (6 vols.) One-speed bicycle Cushioned office chair piece stoneware dinner set Hair brush Cane rocking chair Solid gold locket Encyclopedia Britannica Steinway piano2,4001, Sterling silver teaspoon Things Are Cheaper Today Than 100 Years Ago

How About Today vs 1975? Prices adjusted for inflation and in hours of work required at avg wage Dozen eggs$3.19 (0.16 work hours)$1.58 (0.08 hours) Gallon milk$6.50 (0.32 hours)$3.62 (0.19 hours) Pound of ground beef$3.38 (0.20 hours)$2.77 (0.15 hours) Whole chicken/lb$3.35 (0.18 hours)$1.31 (0.07 hours) Butter/lb$4.54 (0.24 hours)$3.61 (0.19 hours) Tomatoes/lb$1.67 (0.10 hours)$1.92 (0.10 hours) 7.5 oz toothpaste$4.42 (0.17 hours)$2.19 (0.12 hours)

Morning Coffee $ hours $ hours (12 cup)

Expensive TV $3, hours$ hours 32” HD LCD 720p

Clock Radio $ hours$ minutes

$1, hours$ hours MacBook Air

$ hours$ hours

Steel Belted Radial $ hours$78 4 hours Bridgestone Potenza P195/60R-15

Microwave $1, hours$ hours

$2, hours $1, hours Sears Best Home Depot 25 cu ft

9 Principles of Economic Reasoning 1.Due to scarcity, people have to make choices

2. Choices involve tradeoffs and costs Opportunity costs To Choose is to refuse

3. People make decisions by looking at expected costs and expected benefits What is the cost of saving? What is the benefit of saving? Where to save? What investments to purchase?

Where to invest? Microsoft in 1986 cost 11 cents/share. Today it is $28: Turn $1,000 into $250,000 On January 1, 2000 it was worth $500,000 Bear Stearns on March 12, 2008 cost $61.58/share On March 16 cost $2/share

Stocks or Bonds? Returns on $100 Invested in 1928

When and how much to save: Saving and compounding at 6.5% return/year SavesYearsAt age 65 has Maria$2,000/yearAge 22-31$273,000 Tom$2,000/yearAge 32-51$205,000 Sally$2,000/yearAge 22-65$520,000 Juan10% of incomeAge 22-65$940,000

4. People respond to incentives (such as prices) in predictable ways

5. The consequences of decisions are often in the future 1 in five Social Security recipients have no other source of income 1 in three Social Security recipients rely on SS for 90% of their retirement income The average monthly Social Security check is $1,200

Americans’ Dismal Saving: Saving as Percent of Disposable Income

6. Voluntary trade makes people better off and creates wealth

7. Markets are a good way to organize economic activity and increase individual freedom

8. People create economic systems and institutions that influence their choices and outcomes

Starting a Small Business CountryTime RequiredPercent of per capita income needed United States6 days1.4% Brazil120 days7.3% Congo84 days735% Haiti105 days212% Source: World Bank

9. The standard of living of a nation and its citizens is based on their ability to produce goods and services.

Same person, different income

Thinking about how an economy works: I was in discussion with a senior Russian official whose job it was to direct the production of bread in St. Petersburg. “Please understand that we are keen to move towards a market system,” he told me. “But we need to understand the fundamental details of how such a system works. Tell me, for example, who is in charge of the supply of bread to the population of London?” There is nothing naive about his question, because the answer, nobody is in charge, is astonishingly hard to believe. Only in the industrialized West, have we forgotten just how strange it is. --Paul Seabright, The Company of Strangers

Fun, and Interesting, Books About Economics Charles Wheelan, Naked Economics: Undressing the Dismal Science Tim Harford: The Undercover Economist: Exposing Why the Rich are Rich, the Poor are Poor—and Why You can Never Buy a Decent Used Car Steven Landsburg, The Armchair Economist: Economics and Everyday Life P.J. O’Rourke, Eat the Rich: A Treatise on Economics James Surowiecki, The Wisdom of Crowds: Why the Many are Smarter than the Few and How Collective Wisdom Shapes Business, Economies, Societies, and Nations Russell Roberts, The Choice: A Fable of Free Trade and Protectionism Russell Roberts, The Price of Everything: A Parable of Possibility and Prosperity

Break time

Trade, Wealth, Income, and Savings: A Simulation (hour 2)

Education and Income Worldwide

Spot the rich nations

Break time

The Housing and Finance Crisis (hour 3)

Let’s Start a Bank

Bank Balance Sheet Assets Liabilities $10 cash$90 Checking acct $90 cash$10 equity (capital)

And Make a Mortgage

Bank Balance Sheet Assets Liabilities $10 cash$90 Checking acct $90 mortgage (loan)$10 equity (capital)

Background to the crisis Politicians: How to increase homeownership rate? Regulators: How to set international risk-based capital requirements? Individuals: How to increase standard of living? Financial organizations: How to innovate to increase profits? International Investors: Where to put savings?

Why are Low Down Payments Important? Suppose a house costs $200,000 Down payment of 3% = $6,000 Assume house prices rise by 20%/year After 1 year, house is worth $240,000 The $6,000 investment has increased to $40,000; a return of over 500%

Why are low interest rates important to homebuyers? A $425,000 mortgage Standard Fixed Rate Mortgage: $2,150/month Standard Adjustable Rate Mortgage (ARM) $2,100/month Interest Only ARM (pay no principle) $1,800/month Option ARM (pay less than necessary) $1,250 –Note this is cheaper than renting –Note that monthly payment goes up a lot after 1 year This is the average price in Washington DC in It appreciated by 24% from 2005 to 2006

Factors leading up to crisis: Home ownership encouraged by –Federal policies –Low interest rates –Securitization of mortgages –Excessive use of leverage Risk and insurance was underpriced This led to increased demand for housing –A housing bubble developed

Where did the money come from? (I) Listen to Giant Pool of Money on This American

Where did the money come from? II

What is Securitization?

The Extent of Securitization

Factors (continued) When housing prices kept rising, this was not a problem 2006 housing prices peaked Underlying paper (mortages and mortgage backed securities) fall in price Institutions holding paper have losses on balance sheet (asset values fall) How do financial institutions shore up balance sheets?

Housing Prices Rise…

…And get way out of line

And then collapse

Causing problems for owners and banks

23% of Homeowners are Underwater

The Debt Ceiling Problem

Resources –The stock market game –Writing component of stock market game –Resources for teachers on economics and personal finance