The Liberal’s Guide To Economics – short version
At opposite ends of the economics spectrum stand Adam Smith and Karl Marx. But they have one thing in common, both are exceedingly long winded. Rarely does anyone ever read either of them cover to cover. The following is a simple guide to get you started towards understanding how the world works.
Wealth: Wealth is created in only two ways. By mining the earth for valuable materials, potential wealth is converted into kinetic (usable) wealth, and by manufacturing products, raw materials are transformed into usable goods.
Goods: Products have two primary attributes, utility and longevity. A fast food hamburger has a high degree of utility, but its longevity factor is extremely low. At the opposite end of the scale, rests the Great Pyramid in Egypt. Currently it serves no useful purpose other than as a tourist attraction, but it will likely be there for tens of thousands of years. Most other products fall somewhere in between these two.
Services: Individually, we are all service providers. We sell our time and talent to the highest bidder. How our individual service is utilized is critical. Miners, farmers, fisherman, factory workers and many others, all sell their individual service in occupations that create wealth.
A pure service provider does not create wealth. Doctors and lawyers are two examples. They exchange their time for wealth that already exists. Two barbers, who cut each others hair and pass the same ten dollar bill back and forth, do not create wealth. A vast multitude of professions do not create wealth, but do support those who are wealth creators.
Government does not create wealth, aside from manufacturing armaments and repair parts for its own use, it is basically a service provider. As a result, it must fund itself from external sources, by imposing taxes, by borrowing and by creating new money.
Money: The primary purpose of money is to facilitate the efficient exchange of goods and services. A secondary function is as a way of storing wealth. Money stuffed in a mattress only serves the storage function. Money invested or in a savings account circulates back into the economy to serve both functions.
In ancient times there was no money. Tribute was paid to rulers in the form of commodities and labor. Individuals exchanged goods and services for other goods and services. This system of bartering is slow and inefficient. If you have something to sell, a potential buyer may not have a commodity you are interested in accepting. A third or forth party may be required to get all the desired goods into the right hands. In addition, exchanging the exact value of two products can be difficult. With money, exact change is easily made using coins of various value.
The kingdom of Lydia is said to have coined the first money. The nearby Greeks picked up on the idea and developed a trading empire across the Mediterranean. Because money was made using rare metals, its value was easily recognized and accepted. No longer would commodities have to be valued against other commodities, they could each be valued against some form of money.
Inflation: As with any other commodity, the value or buying power of money is determined by the quantity of money available. Maintaining an adequate money supply is a tricky business.
A monetary authority only knows the amount of economic activity that occurred sometime in the past. It does not know what’s happening today.
If the economy is growing at a rate of 3 percent per year, then the supply of money needs to grow at the same rate to maintain efficiency in the marketplace. In this situation, overall price levels will remain constant.
If the economy grows at 3 percent annually and the supply of money grows at 6 percent, then the money supply is being inflated at 3 percent and eventually the buying power of the currency will start to decline at a rate of 3 percent per year.
The basis of all human activity on this Earth is production and consumption. Throughout history, food has been the primary product that we annually produce and then consume. Many a civilization has moved, collapsed or even vanished when food production was interrupted.
Production: Production is the process of creating wealth. When raw materials are processed into finished products, wealth is created. Iron ore in the ground has no functional value. As it moves from the mine, to the steel mill, to the factory, it gains value as it transforms into steel and finally into a finished product you want to use.
Consumption: We are all consumers. Most of us acquire “goods” to make our life easier and to make us happy. As consumers, we are actually destroyers if wealth. We buy a product and proceed to use it until it is no longer useable. Some products are meant to just be collectable, but most are used and abused and eventually reduced to rubble.
Debt: Borrowed money can be invested in ways that enhance productivity, thus generating the wealth needed to pay back the debt. Borrowing money to buy a home or car can enhance your ability to be productive. Corporations borrow to build factories or buy machinery needed to manufacture a product. Government borrowing to build roads and bridges enhances the productivity potential of the entire private sector.
In the 1970’s, some nations borrowed money not to enhance productivity, but to subsidize the cost of food. This made life more comfortable for their citizens, but there was no possibility of paying off the loans. Eventually new loans were made to provide funding to make the interest payments on the previous loans. This was obviously an unsustainable policy.
The Magic Formula: Nations, when they are successful, adhere to a basic mathematical formula. It is really quite simple, (P – C = G). Production minus Consumption equals Growth.
To derive a more useful result, the equation would read as follows, ((P-C)/P)*100=G. The result is a percentage of growth either positive or negative which can be compared to other years.
A positive G value results in a higher standard of living. When a nation produces more wealth than it consumes, the surplus can be used to build infrastructure, either public or private, that will result in a higher standard of living. A negative G leads to a lower standard of living. When a nation consumes more wealth than it creates, it is burning through any accumulated wealth it may have. Infrastructure deteriorates, personal wealth disappears and the general standard of living goes down.
In the short term, a nation with negative wealth production can maintain its current standard of living by borrowing the surplus productivity of other nations. But this can not go on indefinitely. Eventually, interest payments become unsustainable. The formula then changes to P – ( C + I ) = G. Typically governments try to beat the system by passing laws and printing money. This has yet to ever be successful in the long run.
Wherever you look on planet Earth you will find some nations running a wealth surplus and other countries a deficit. Those with a surplus have a constantly improved standard of living. Those with a negative “G” value have a stagnant or declining living standard.
1776 to 1976:
Consider the world that George Washington lived in. The roads were dirt. When it rained, they turned to mud. Town centers might have a central area covered with paving bricks, but this was not wide spread. Transport was by foot, on horseback, buggy, wagon, Conestoga freight wagon or what we commonly think of as the western stage coach, actually developed in England in the 16th century.
Sailing ships hauled goods and materials up and down the east coast and across the ocean. Barges pulled by teams of horses moved goods up and down rivers. The first useful steam engine came along in 1781 in England, but it took until the 1830’s for the steam railroad system to start. For George Washington, there was no steam engine, railroad, car, truck, bus, telegraph, phone or airplane.
The question arises, how did we get from George’s 1776 world to our modern world of electronics, hybrid drive and instant everything? For 200 years America produced substantially more than it consumed. This surplus of wealth production provided the capital and spare time to invent new things, develop new products and new industries.
The Wright brothers made their living building bicycles. In their spare time they developed a flying machine. Edison, Tesla, Ford and many others all held day jobs and did their inventing after working hours.
There are two definable economic systems constantly at work. The inter-family system and the intra-family system. Initially, human children cannot survive on their own. In terms of economics, parents provide a subsidized existence that allows children to develop the strength and skills needed to survive independently. In some countries, this subsidy lasts a bare minimum amount of time, in other countries the subsidy can go on for twenty years or more. This intra-family economic system is part of human nature. Outside of the family, the other economic system is the norm. Self interest rules. We exchange our time and assets at market value. The teenager down the street will cut your lawn for a fee, not out of the goodness of his heart.
Supply, Demand and Price: The marketplace sets the price of a commodity based on supply and demand. Sand has many practical uses. In spite of fairly high demand, its price is relatively low because it is widely available. In comparison, diamonds and gold are rare and therefore command a high price even though they have limited practical uses. During the decades when Spain imported shiploads of gold from the new world, the buying power of gold coins dropped in half.
Final thought: There are two types of people in this world, those who create a mutual benefit for themselves and others and those who benefit themselves, at the expense of others.