What are the fundamental forces that drives an economy forward? What are the mistakes that may cause it to crash?
Video by the Swedish Investor
Key Takeaways
Unfortunately, what politicians do today in many modern economies is harmful in the long run, but it keeps attracting the votes of the people nonetheless.
Over the past century or so, academics have made great progress in many areas including Albert Einstein’s progress on the theory of relativity, Alexander Fleming and his discovery of penicillin, Francis Crick and James Watson discoveries about DNA etc.
However, this one field of research where we haven’t made much progress and that’s within the field of economics.
Top 5 Takeaways
1. The Primary Goal: Increasing Productivity
A good definition of an economy is this: the effort to maximize the availability of limited resources to meet as many human demands as possible.
Say that it previously took people an average of 0.2 working days to meet their daily demand of food. A thousand days to meet their demand of getting a shelter. Ten days to get that neat smartphone and 600 days for the super car.
But today, it only takes 0.1 days, 500 days, five days, and 300 days to meet those demands.
The economy has then been growing.
An increase in productivity has allowed food, shelter, smartphones, and super cars that of course are limited in their quantity, to become more readily available to the general population.
This is the goal of an economy.
Think about it. Compared to before, you can now get a house, a supercar, ten smart phones for all your relatives and food for a thousand days and still have 50 days left for leisure time. Compared to buying just one house before.
This must be a good thing, just think about how many days you can spend with reading books in a nice hammock.
Super cars don’t produce themselves at the price of 300 working days, instead of 600 days, just by coincidence. There are a few prerequisites for this. It usually takes new tools, which come from innovation, which in turn comes from savings and risk-taking.
No person is particularly innovative if he has to work all day just to fulfill the basic need of putting food on the table for his family.
For an economy to increase its productivity then, which is the primary goal, savings are required and this is what we’ll cover in the next takeaway.
2. Savings Benefit Everyone
Why savings are important for an economy to grow is quite easy to illustrate. Peter Schiff provides an excellent illustration in How an Economy Grows and Why it Crashes, about three fishermen living on a deserted island, but for that you’ll have to get the book yourself.
However, just think about it like this:
Such projects cost up to many thousand days of savings from many thousand individuals to complete.
There are four primary ways which savings can be used:
1. They could be saved for a rainy day.
2. Consumed for extra pleasure.
3. Lent out to someone in need.
4. Invested.
1. Saved
The first alternative doesn’t really help the economy grow directly, but it is a great buffer for times of turmoil. Some individuals, companies, and governments have learned this the hard way during the current pandemic.
2. Consumed
The second alternative doesn’t help the economy grow. This is the worst use of savings.
The economy doesn’t grow because we consume more. We consume more because the economy grows.
According to Peter Schiff, thinking that we can spend ourselves out of economic troubles is the main problem with the current paradigm within the field of economics.
Consuming more than we can afford today will eventually be troublesome. Either for our future selves or for our children.
3. Lent Out
Loans are the third alternative and if they are made for business purposes, rob them for consumption they can really help an economy grow.
Just think about the aspiring entrepreneur. Without savings from either himself or someone else, he or she can’t possibly build his own business because he’ll need a steady stream of income to put food on the table for his family.
4. Invested
By looking at these four alternatives, it’s easy to see that a capitalistic economy works.
The lender wants interest payments and the investor wants dividends and these are both selfish motives, but they will have positive spillover effects to everyone else in the economy too.
If the person who has savings wants to earn more on those savings, he’ll have to invest or lend them out to others.
A very important concept here is opportunity costs. Just like pretty much everything else, savings are limited. Savings that are used for consumption, could have been used for business loans or investments.
It is therefore harmful for the growth of our economies that most governments are running monetary policies which incentivize consumption, but disincentive lending and investments. (More on this later)
3. Comparative Advantage
Once upon a time there existed an economy where only food, shelter, smartphones, and super cars really mattered. In other words, not too different from the one that we have today.
In this economy, only four people lived: Able, Babel, Cable and Durable.
They were all equally interested in food, shelter, smartphones and super cars. What they weren’t though was equally efficient in producing these items.
Babel, Cable and Durable could produce one day’s worth of food by working zero point two days, while Abel could produce it in just 0.1 days.
Babel was the most efficient shelter producer. He could build one in only 500 days, while it took the others a thousand.
Cable was a gifted smartphone designer and it took him just five days to produce one, while it took the others ten days.
Similarly, Durable was the most skilled super car maker at a production time over 300 days, instead of 600 days like the others.
If they use their talents in an optimal way, they should let Abel produce the food, Babel build the shelters, Cable assemble the smartphones, and Durable make the super cars.
Over a lifetime, they each demand food for about thirty thousand days, five houses, 500 smartphones, yes these guys are quite clumsy, and ten super cars.
Now if they don’t use their skills, or comparative advantages, in an optimal ways and produce everything themselves, they would each have about ten to eleven thousand days of leisure over a lifetime.
However if they use their comparative advantages and let each do what he is best at and then trade goods with each other, they’ll have between eighteen to twenty thousand days.
Simply put, if workers in an economy specialized at what they are best at, the productivity of the economy will grow.
Comparative advantages are important for the economy within the country, but it is also important for the total economy across the globe.
For instance if King and Ling who come from an outside country of Able, Babel, Cable and Durable, would be capable of producing food in just 0.05 working days and shelters in just 250, everyone could have even more leisure time.
Moreover, more savings would be available for business loans and investments, which could increase the productivity of the economy even further down the line.
You might ask, but what would then happen to Able and Babel?
Well with some savings or potentially a business loan from Cable and Durable, they would probably discover that everyone is also interested in buying some fancy clothes and fancy watches, now that there’s so much leisure time.
Remember this: the goal of an economy is not to provide jobs. The goal is to maximize productivity.
In an economy where productivity is increasing and comparative advantages are maximized, the prices should actually be decreasing.
4. The Role of the Government
There are a few services that arguably should be provided to everyone in an economy and that for one reason or another, are poorly provided by a free market.
Almost everyone agrees that to such needs are those of personal safety, and justice.
- For example: Abel, Babel, Cable and Durable might consider giving away some of their production to hire Enable for security, and Fable for justice.
- Enable and Fable would then be hired as this country’s governmental employees.
One important thing to notice here is this—the government itself doesn’t produce the basic needs of the economy, it uses the taxpayer savings to provide services.
For this reason government spending is the same as taxpayers spending. Never forget this.
A bit more questionable is when the government starts to provide services like health care, infrastructure, education, and banking. (We’ll get to bank in the final take away).
Sure, these are all services that are demanded in a modern economy, there’s no discussion about that.
The question is just if the government can provide them in a more efficient way than the marketplace can.
Private lenders on the other hand, only spend savings where it is economically defensible to do so. Because of this, private lending is more efficient in bringing out the strongest species and speed up the evolution in society.
Once again the key concept is opportunity costs.
Savings are necessary for the economy to grow, as we’ve seen previously but, they come in limited quantity and remember that the government is nothing more than a facilitator of private savings.
If the savings are wasted, the economy grows much slower than it could have. In some cases it even causes it to crash.
During the financial crisis for instance, it could be argued that the government played an important part in the downfall.
The boom that occurred in housing prices was partly caused by governmental actions.
The federal interest rates had been lowered to make borrowing cheaper and banks were incentivized to issue riskier mortgages as they knew that they could sell these loans immediately to two governmental entities called Fannie Mae and Freddie Mac.
In other words, the government decided that American private savings should go towards an upgrade in the housing standards of its people. Especially people with limited finances. Let’s just say that this turned out to be a very poor use of savings.
If you want to hear more about the ‘whats’ and ‘whys’ of the financial crisis check out the summary of “A History of the United States in Five Crashes”.
5. The Function of Banks
Banks facilitates two great functions in society.
1. They allow people to save in a safe way.
2. They may take more educated decisions when it comes to how the savings should be allocated than the average individual.
In this way, banks increase the productivity of savings.
1. Desire to maximize returns on deposits.
2. Fear of losing capital on risky projects.
3. Time preference for consumption.
In the US, the Fed is effectively determining the price of money by deciding the interest rates at which all other banks can borrow and lend at through the federal funds rate.
1. The federal representatives do not have the same ‘skin in the game’ as the owner of a bank has. For this reason, they make short-term decisions that the business owner of an individual bank would never do.
2. It is very questionable if the centralized Fed can make more informed decisions than the aggregate of millions of independent decisions—well that is more or less independent in the marketplace.
3. The Fed typically makes decisions that are based on political rather than economical factors.
- The chairman of the Fed, for example, is nominated by the President of the US. So the fate of the President and the Fed chair are intertwined and I bet that you understand yourself what type of consequences this might have.
The inflationary monetary policies that are followed today are harmful to our economies.
They are harmful because they incentivize spending instead of saving. This is important. Inflation is simply a means to transfer wealth from anyone who has savings in a particular currency, to anyone who has debt in the same currency.
**As we saw in takeaway number two, savings are necessary for an economy to grow.
Moreover credit and leverage being used in a stupid way has been one of the primary reasons of all of five of the greatest economical crashes in history.
If you’d like to hear more about these crashes and possibly become a little bit more aware of what might cause them in the future, check out the summary of the book “A History of the United States in Five Crashes”.