Number one: the invisible hand.

An economy is a tricky thing to control and governments are always

trying to figure out how to do it. Back in 1776, economist Adam Smith shocked everyone by saying that
what governments should actually do, is just leave people alone to buy and sell freely among
themselves. He suggested that if they just leave self-interested traders to compete with one another,
markets are guided for positive outcomes as if by an invisible hand. If someone charges less than you,
customers will buy from them instead, so you have to lower the price or offer something better.
Whenever enough people demand something, they will be supplied by the market, like spoiled children,
only in this case everyone's happy. Later free marketeers like Austrian economist, Friedrich Hayek,
argued that this hands-off approach actually works better than any kind of central plan. But the problem
is economies can take a long time to reach their equilibrium and may even stall along the way, and in
the meantime people can get a little frustrated. Which is why governments usually end up taking things
into their own more visible hands instead.

Number two: the paradox of thrift. Much like a child getting his pocket money, one of the biggest
economic questions is still whether it's better to save or spend. Free marketeers like Hayek and Milton
Friedman say that even in difficult times, it's best to be thrifty and save. Banks then channel the savings
into investment, in new plant skills and techniques that let us produce more. And even if this new
technology destroys jobs, wages will drop and businesses hire more people, so unemployment falls
again, simple. At least in the long run. But then a 'live fast die' young kind of chap called John Maynard
Keynes, cheerfully pointed out that in the long run we're all dead, so to avoid the misery of
unemployment, the government should instead spend money to create jobs. Whereas if the
government tightens its belt when people and businesses are doing the same, less is spent, so
unemployment gets even worse. That is the paradox of thrift. So instead they should spend now and tax
later when everyone's happy to pay. Though making people happy to pay tax for something even Keynes
didn't solve.

Number three: The Phillips Curve. Bill Phillips was a crocodile hunter and economist from New Zealand,
who spotted that when employment levels are high, wages rise faster. People have more money to
spend so prices go up and so does inflation, and likewise, when unemployment is high, the lack of
money to spend means that inflation goes down. This became known as The Phillips Curve.
Governments even set policy by the curve, tolerating the inflation when they spent extra money
creating jobs. But they forgot that the workers could also see the effects of the curve, so when
unemployment went down, they expected inflation and demanded higher wages causing
unemployment to go back up, while inflation remained high. Which is what happened in the 1970's,
when both inflation and unemployment rose. Then in the 90's, unemployment dropped, while inflation
stayed low, which all rather took the bend out of Phillips's Curve. But at least part of Phillips's
troublesome trade-off lives on. When faster growth and full employment return, you can bet inflation
will be along to spoil the party.

Number 4: The Principle of Comparative Advantage. Whether you think economies work best if they're
left alone, or the government's need to do something to get them working the one thing that can't be
controlled is the rest of the world. Fear of foreign competition once led countries to try and produce
everything they needed and impose heavy taxes to keep out foreign goods. However, economist David
Ricardo showed that international trade could actually make everyone better off bringing in one of the
first great economic models. He pointed out that even if a country can produce pretty much everything
at the lowest possible cost, with what economists call an absolute advantage, it's still better to focus on
the products it can make most efficiently that sacrifice the least amount of other goods and let the rest
of the world do the same. By specialising, they can then export these surpluses to each other and both
end up better off. This is the principle of comparative advantage and it has persuaded many countries to
sign up to free-trade agreements, but unfortunately it can take a long time for countries to trade their
way to prosperity. And because it's now much easier to move to where money is, it's increasingly not
only goods that cross borders but people, which has somewhat uprooted Ricardo's theory.

Number Five: The Impossible Trinity. Most countries trade with one another, which is usually pretty
good for all involved. But it does mean it's a bit harder for each to keep control of its own finances.
There are three things that governments are particularly keen on. They like to keep the exchange rate
stable so that import and export prices don't suddenly jump around. They also like to control interest
rates so they can keep borrowers happy without upsetting savers. And they like to let money flow in and
out of their country, without causing too much disruption. But there's a problem when you try to do all
of these at once. Say, for example, the euro-zone tries to lower its interest rate and reduce
unemployment. Money flows out to earn higher interest rates elsewhere. Exchange rates drop, which
causes inflation, so the Euro interest rate is forced back up again. You can either fix your exchange rate
and let money float freely across national borders, but have no control over your interest rates, or
control your interest and exchange rates, but then you can't stop the capital flowing in and out. But like
an overzealous triathlete, you can't do all three at once.

Number Six: Rational Choice Theory. Of all the things to factor in when running an economy, the most
troublesome is people. Now, by and large, humans are a rational lot, when the price of something rises
people will supply more of it and buy less of it. If they expect inflation to go up, people will usually ask
for higher wages, though they might not get them. And if they can see interest or exchange rates falling
in one country, people with lots of money there will try to move it out faster than you can say double-
dip. And governments often decide their economic policies, assuming such rational actions. Which
would be great, if it weren't for the fact that those pesky humans don't always do what's best for them.
Sometimes they mistakenly think they know all the facts, or maybe the facts are just too complicated.
And sometimes, people just decide to follow the crowd, relying on others to know what they're doing.
When too many cheap mortgages were being sold in 2007, a lot of people didn't know what was going
on. And a lot of others just followed the crowd. Some lenders may have rationally believed that when
the crunch came the scale of the problem would force governments to rescue them. Which was true for
the banks, if not for all their customers.