The Role of Global Economics in Your Small Business
Did you know your small business can feel the impact of the global economy before larger businesses are affected? Small businesses, because of their size and more streamlined decision-making process, have certain advantages over their larger counterparts. Yes, even small business leaders should pay close attention to what is happening with the economy on a global scale.
Economics gets complicated, especially as the world becomes more connected. A stubbed toe in Belgium can cause a broken foot in the United States. This doesn’t necessarily mean you should hire an economist, or sign up for college courses on macro and microeconomics, but there are three statistics you should keep track of to stay informed:
Gross Domestic Product (GDP) measures the size and health of the U.S. economy. It is calculated as the value of all goods and services produced in the U.S. In 2019, GDP was $21.4 trillion. It’s not just the size of GDP that matters. Most economists are interested in the growth of GDP more than the size. When GDP growth is around 2.8% to 3.5%, our economy tends to signal a positive economic outlook. GDP under 2.8 tends to indicate a sluggish economy, which sparks fears of recession. When GDP exceeds 3.5%, the economy could be growing too fast, creating a whole different set of problems.
When GDP is lower, many economists begin to fear it may trigger a recession. Public spending slows, inventory grows, and supply and demand move in favor of buyers. Despite how they sound, none of these scenarios are inherently “bad.” Businesses which understand the economy tend to find value in any fluctuations, up or down. In a “down economy” or recession, buyers can find value when interest rates and prices start to drop, and producers can clear their warehouses. Cash is king, and if you have cash during a recession, you can get more value for your purchases.
The textbook definition of a recession is when GDP shrinks for two consecutive quarters. However, while recessions are officially declared by the National Bureau of Economic Research (NBER), they unofficially become the topic of discussion when GDP dips below 2.8% in a quarter.
A GDP growing at a rate of 3.5% or higher tends to make economists jittery because it indicates an economy that is growing too rapidly. With this type of growth, there tends to be more spending. So much so that spending can outpace value. The economy begins to feed on itself in a way that drives prices and interest rates higher. The economy can reach unsustainable levels, resulting in a crash. When you see this happen, you may want to be cautious about spending but bullish on selling or manufacturing more products. This is not a good time to take on debt but may be a good time to lend if you are in the position.
Most governments track and publish GDP data through a national statistical agency. In the US, GDP is calculated by the Bureau of Economic Analysis using data collected by various governmental and private sources, including the Census Bureau, Internal Revenue Service, Federal Reserve, and Bureau of Labor Statistics.
While GDP estimates vary from various international agencies such as the International Monetary Fund, the World Bank, and the United Nations, the United States is generally regarded as having the largest GDP of any country in the world.
While GDP is the most important statistic you can use to develop short-term strategies, look to the Federal Open Market Committee (FOMC) when you’re trying to read the economic tea leaves. The FOMC consists of the Chairperson of the Federal Reserve Banking System (The Central Bank) and the heads of all Federal Reserve branches across the U.S. This committee, along with the Treasurer of the United States, creates monetary policy and sets the Federal Reserve interest rates. The two rates you generally hear about are the discount rate, and the prime rate.
The discount rate is the rate set for bank-to-bank lending. Banks can borrow from each other in the form of repurchase agreements (REPOS), or they can borrow through the Federal Reserve bank, although it’s discouraged and is usually reserved for when a bank is having problems. This is usually the lowest of the rates that the FOMC targets. These rates are based on the FOMC’s view of the economy and trying to keep GDP at 2.8%.
The second rate, and the rate most people know when they borrow money is the prime rate. Prime rate is the lowest rate of interest at which money may be borrowed commercially. Mortgages, car loans, and credit card debt represent loans where the rate of interest you pay is calculated based on the prime rate. For example, if you’ve ever heard a banker or lender say “prime plus fifty,” that means your interest rate is equal to the prime rate plus fifty basis points, or .5%. Any number stated after the prime rate is the spread that the lender receives. So in our example above, the lender is typically borrowing the money to lend you at prime and then charging you an additional .5% which is what they’re making on your loan.
If the FOMC lowers interest rates, it’s usually in an attempt to head off a recession. When the FOMC raises interest rates, they are usually trying to reign in a steep rise in the economy.
Historically, measuring the money supply has shown that relationships exist between those measurements, inflation, and price levels. Since 2000, however, these relationships have become unstable, reducing their reliability as a guide for monetary policy. Although money supply measures are still widely used, they are only one of a wide array of economic data that economists and the Federal Reserve collect and review.
The U.S. is a net borrowing country. That means that our government borrows funds it needs to offset costs. The FOMC also decides when to increase the money supply or borrow money. They do this through treasury bills, notes and bonds. We’re also the only country in the world that can issue these treasury bonds, and they have complete liquidity. These instruments are backed by the “Full Faith and Credit of the United States of America.” If the U.S. were to default on any payments, the results would be cataclysmic!
The final of the three statistics you should pay attention to is inflation. There’s a good reason why inflation has been mentioned in each of the indicators I’ve discussed so far. Economies are largely reactionary, meaning they reflect the actions and intentions of the businesses, governments and citizens. Inflation, by nature, is also a reaction to the actions and intentions of those who wish to invest in a country or lend a country money. In the U.S., we control and stabilize our economy through the Federal Reserve and the FOMC.
The FOMC has monthly meetings at which they will issue and publish the minutes of their conference. These minutes act as indicators to what they see happening and what they intend to do about it. They will have analyzed all the indicators we’ve discussed and more. Their minutes may show that they’re happy with the rate of inflation (less than 4%) and intend to leave interest rates alone for now, but might see interest rates increase the next six months. They rarely take any actions without significant clear warning.
Economies are delicate balances, and every detail will influence the others. It’s crucial to understand how economic occurrences in China or Europe, for example, can affect the economy here in the U.S. If you can keep an ear to the ground to monitor these indicators, you will make your business more successful. Money can be made no matter what the indicators say as long as you know which direction to go, and if needed you can always hire an expert.