• INFORMATION
• The oil that keeps the economy working smoothly. Economic EFFICIENCY is likely to be greatest when information is comprehensive, accurate and cheaply available. Many of the problems facing economies arise from people making decisions without all the information they need. One reason for the failure of the COMMAND ECONOMY is that GOVERNMENT planners were not good at gathering and processing information. Adam SMITH’s metaphor of the INVISIBLE HAND is all about how, in many cases, free markets are much more efficient at processing information on the needs of all the participants in an economy than is the visible, and often dead, hand of state planners. ASYMMETRIC INFORMATION, when one party to a deal knows more than the other party, can be a serious source of inefficiency and MARKET FAILURE. Uncertainty can also impose large economic costs. The internet, by greatly increasing the availability and lowering the price of information, is helping to boost economic efficiency. But there are inefficiencies the internet will not be able to solve. Uncertainty will remain a huge source of economic inefficiency. Alas, potentially the most useful information, about what will happen in the future, is never available until it is too late.
• INFRASTRUCTURE
• The economic arteries and veins. Roads, ports, railways, airports, power lines, pipes and wires that enable people, goods, commodities, water, energy and INFORMATION to move about efficiently. Increasingly, infrastructure is regarded as a crucial source of economic COMPETITIVENESS. INVESTMENT in infrastructure can yield unusually high returns because it increases people’s choices: of where to live and work, what to consume, what sort of economic activities to carry out, and of other people to communicate with. Some parts of a country’s infrastructure may be a NATURAL MONOPOLY, such as water pipes. Others, such as traffic lights, may be PUBLIC GOODS. Some may have a NETWORK EFFECT, such as telephone cables. Each of these factors has encouraged GOVERNMENT provision of infra¬structure, often with the familiar downsides of state intervention: bad planning, inefficient delivery and CORRUPTION.
• INNOVATION
• A vital contributor to economic GROWTH. The big challenge for FIRMS and governments is to make it happen more often. Although nobody is entirely sure why innovation takes place, new theories of ENDOGENOUS growth try to model the innovation process, rather than just assume it happens for unexplained, EXOGENOUS reasons. The role of incentives seems to be particularly important. Although some innovations are the result of scientists and others engaged in the noble pursuit of know¬ledge, most, especially their commercial applications, are the result of entrepreneurs seeking PROFIT. Joseph SCHUMPETER, a leading practitioner of AUSTRIAN ECONOMICS, described this as a process of “creative destruction”. A firm innovates successfully and is rewarded with unusually high profits, which in turn encourages rivals to come up with a superior innovation.
• To encourage innovation, innovators must be allowed to make a decent profit, otherwise they will not incur the RISK and expense of trying to come up with useful innovations. Most countries have PATENTS and other laws protecting intellectual property, which allow innovators to enjoy a (usually temporary) MONOPOLY over their innovation. Economists disagree over how long that protection should last, given the inefficiencies that result from any monopoly.
• For most of the second half of the 20th century, governments played a crucial role in funding and directing pure research and early-stage development. In the 1980s, however, legal changes in the United States started to reduce this role. One change aimed to move technological development out of the country’s state-financed national laboratories. Another allowed universities, not-for-profit research institutes and small businesses doing research under government contract to keep the technologies they had developed and to apply for patents in their own names. This appears to have contributed to a surge in innovation in the United States, as government researchers and university professors teamed up with outside FIRMS, or started their own. Hoping for similar results, many other countries have followed suit.
• Is innovation all it is cracked up to be, or is it just change for change’s sake? A few years ago, Robert Solow, a Nobel prize-winning economist, observed that “you can see the computer age everywhere these days except in the PRODUCTIVITY statistics”. Although new computer technology clearly had affected people and firms in visible and obvious ways, the slowdown in productivity growth that had afflicted the American economy since the 1970s did not appear to have been reversed. Believers in the NEW ECONOMY argued that the “Solow Paradox” no longer holds true; in the late 1990s, the computer revolution started to deliver the productivity growth long promised. Even so, this shows that innovation can take a long time to deliver the goods.
• INSIDER TRADING
• A practice that was made illegal in the United States in 1934 and in the UK in 1980, and is now banned (for SHARES, at least) in most countries. Insider trading involves using INFORMATION that is not in the public domain but that will move the PRICE of a share, BOND or currency when it is made public. An insider trade takes place when someone with privileged, confidential access to that information trades to take advantage of the fact that prices will move when the news gets out. This is frowned on because investors may lose confidence in FINANCIAL MARKETS if they see insiders taking advantage of advantageous ASYMMETRIC INFORMATION to enrich themselves at the expense of outsiders. But some economists reckon that insider trading leads to more efficient markets: by transmitting the inside information to the market, it makes the price of, say, a company’s shares more accurate. This may be true, but most financial regulators are willing to sacrifice a degree of accuracy in pricing to ensure that outsiders (the great majority of investors) feel they are being treated fairly.
• INSTITUTIONAL ECONOMICS
• See EVOLUTIONARY ECONOMICS.
• INSTITUTIONAL INVESTORS
• The big hitters of the FINANCIAL MARKETS: pension funds, fund-management companies, INSURANCE companies, investment BANKS, HEDGE FUNDS, charitable endowment trusts. In the United States, around half of publicly traded SHARES are owned by institutions and half by individual investors. In the UK, institutions own over two-thirds of listed shares. This gives them considerable clout, including the ability to move the PRICES in financial markets and to call company bosses to account. But because institutions mostly invest other people’s MONEY, they are themselves prone to AGENCY COSTS, sometimes acting against the best long-term interests of the people who trust them with their SAVINGS.
• INSURANCE
• In economic terms, anything used to reduce the downside of RISK. In its most familiar form, insurance is provided through a policy purchased from an insurance company. But a fuller definition would also include, say, a financial SECURITY (or anything else) used to HEDGE, as well as assistance available in the event of disaster. It could even be provided by the GOVERNMENT, in various ways, including WELFARE payments to sick or poor people and legal protection from CREDITORS in the event of BANKRUPTCY.
• Conventional insurance works by pooling the risks of many people (or FIRMS, and so on), all of whom might claim but in practice only a few actually do. The cost of providing assistance to those that claim is spread over all the potential claimants, thus making the insurance affordable to all.
• Despite the enormous attraction of insurance, private markets in insurance often work badly, or not at all. Economists have identified three main reasons for this.
• • Private firms are unwilling to provide insurance if they are uncertain about the likely cost of providing sufficient cover, especially if it is potentially unlimited.
• • MORAL HAZARD means that people with insurance may take greater risks because they know they are protected, so the insurer may get a bigger bill than it bargained for.
• • Insurers are at risk of ADVERSE SELECTION. The people who are most likely to claim buy insurance, and those who are least likely to claim do not buy it. In this situation, setting a PRICE for insurance that will generate enough premiums to cover all claims is tricky, if not impossible.
• Insurers have found ways of reducing the impact of these problems. For example, to counter adverse selection, they set higher health-insurance rates for people who smoke. To limit moral hazard, they offer reduced premiums to people who agree to pay the first so-many dollars or pounds of any claim.
• An efficient system of insurance, in its broadest sense, can contribute to economic GROWTH by encouraging entrepreneurial risk taking and by enabling people to choose which risks they take and which they protect themselves against.
• INTANGIBLE ASSETS
• Valuable things, even though you cannot drop them on your foot – an idea, say, especially one protected by a PATENT; an effective corporate culture; HUMAN CAPITAL; a popular brand. Contrast with TANGIBLE ASSETS.
• INTELLECTUAL CAPITAL
• The part of a country's or a firm’s CAPITAL or an individual’s HUMAN CAPITAL that consists of ideas rather than something more physical. It can often be protected through PATENTS or other intellectual property laws.
• INTEREST
• The cost of borrowing, which compensates lenders for the RISK they take in making their money available to borrowers. Without interest there would be little lending and thus a lot less economic activity. The charging of interest is contrary to Sharia (Islamic) law, being considered USURY. Some American states also have usury laws, imposing tough conditions on the terms set by lenders, although not actually prohibiting interest. Yet, as the recent rise of a substantial banking industry in Islamic Middle Eastern countries shows, when economic GROWTH is a priority, ways can usually be found to pay lenders to lend.
• INTEREST RATE
• INTEREST is usually expressed at an annual rate: the amount of interest that would be paid during a year divided by the amount of money loaned. Developed economies offer many different interest rates, reflecting the length of the loan and the riskiness and wealth of the borrower. People often use the term “interest rate” when they mean the short-term interest rate charged to BANKS. For instance, when a CENTRAL BANK raises or cuts interest rates, it changes only the PRICE it charges to banks borrowing money overnight, expressed as an annual rate. BOND YIELDS are a better measure of the interest rate on loans that do not have to be repaid for many years. Unlike short-term interest rates, bond yields are determined not by central bankers but by the SUPPLY and DEMAND for MONEY, which is heavily influenced by the expected rate of INFLATION.
• INTERNATIONAL AID
• A helping hand for poor countries from rich countries. This, at least, is the intention. In practice, in many cases aid has done little good for its intended recipients (improved health care is a notable exception) and has sometimes made matters worse. Poor countries that receive lots of aid grow no faster, on average, than those that receive very little. By contrast, perhaps the most successful aid programme ever – the MARSHALL PLAN for rebuilding Europe after the second world war – involved rich countries giving to other hitherto rich countries.
• During the second half of the 20th century rich countries gave over $1 trillion in aid to poor ones. During the 1990s, however, flows of official aid stagnated. In 2001, official aid was a little over $50 billion, roughly one quarter of the GDP of donor countries. On top of this were private-sector donations from NGOs (non-government organisations) worth an estimated $6 billion. Increasingly, such sums were exceeded by private FOREIGN DIRECT INVESTMENT. In an attempt to reinvigorate international aid, in 2000 the UN committed itself to eight ambitious Millennium Development Goals for reducing global poverty by 2015.
• Why has aid achieved so little? Donations have often ended up in the OFFSHORE BANK accounts of corrupt politicians and officials in poor countries. MONEY has often been given with strings attached, so that much of this “tied” aid is spent on com¬panies and corrupt politicians and officials in the donor country. War has ravaged many potentially beneficial aid projects. Moreover, some aid has been motivated by political goals – for example, shoring up anti-communist governments – rather than economic ones.
• The lesson of history is that aid will often be wasted unless it is carefully aimed at countries with a genuine commitment to sound economic management. Analysis by the WORLD BANK sorted 56 aid-receiving countries by the quality of their economic management. Those with good policies (low INFLATION, a BUDGET surplus and openness to trade) and good institutions (little CORRUPTION, strong rule of law, effective bureaucracy) benefited from the aid they received. Those with poor policies and institutions did not. This accounts for the growing popularity of CONDITIONALITY in aid.
• INTERNATIONAL LABOUR ORGANISATION
• See ILO.
• INTERNATIONAL MONETARY FUND
• See IMF.
• INTERNATIONAL TRADE
• See FREE TRADE.
• INTERVENTION
• When CENTRAL BANKS try to influence an EXCHANGE RATE by buying the currency they want to appreciate and selling the one they want to weaken. The evidence seems to suggest that it is at best a short-term measure. In the longer term, governments probably do not have the resources to beat MARKET FORCES.
• INVESTMENT
• Putting MONEY to work, in the hope of making even more money. Investment takes two main forms: direct spending on buildings, machinery and so forth, and indirect spending on financial SECURITIES, such as BONDS and SHARES.
• Traditionally, economic theory says that a country’s total investment must equal its total SAVINGS. But this has never been true in the short run and, as a result of GLOBALISATION, may never be even in the long run, as countries with low savings can attract investment from overseas and foreign savers lacking opportunities at home can invest abroad (see FOREIGN DIRECT INVESTMENT).
• The more of its GDP a country invests, the faster its economy should grow. This is why GOVERNMENTS try so hard to increase total investment, for instance, using tax breaks and subsidies, or direct PUBLIC SPENDING on INFRASTRUCTURE. However, recent evidence suggests that the best way to encourage private-sector investment is to pursue stable macroeconomic policies, with low INFLATION, low INTEREST RATES and low rates of TAXATION. Curiously, economic studies have not found evidence that higher levels of investment lead to higher rates of GDP GROWTH. One explanation for this is that the circumstances and manner in which money is invested count at least as much as the total sums invested. It ain’t how much you do, it’s the way that you do it.
• INVISIBLE HAND
• Adam SMITH’s shorthand for the ability of the free market to allocate FACTORS OF PRODUCTION, goods and SERVICES to their most valuable use. If everybody acts from self-interest, spurred on by the PROFIT motive, then the economy will work more efficiently, and more productively, than it would do were economic activity directed instead by some sort of central planner. It is, wrote Smith, as if an “invisible hand” guides the actions of individuals to combine for the common good. Smith recognised that the invisible hand was not infallible, however, and that some GOVERNMENT action might be needed, such as to impose ANTITRUST laws, enforce PROPERTY RIGHTS, and to provide policing and national defence.
• INVISIBLE TRADE
• EXPORTS and IMPORTS of things you cannot touch or see: SERVICES, such as banking or advertising and other intangibles, such as copyrights. Invisible trade accounts for a growing slice of the value of world trade.
• INWARD INVESTMENT
• Investment from abroad; the opposite of OUTWARD INVESTMENT (see FOREIGN DIRECT INVESTMENT).