Thursday, March 31, 2005

Economics 101

Many people have incorrect assumptions about money. First among these is that money is anything other than a method of scorekeeping for wealth. This in turn leads to the misconception that one person's gain is another's loss.

An example of this world economy shakes out like this:

assume that there are four people on the planet, each with $5.00

Name: Lumberjack
Bank: $5.00
Needs: Food, Shelter, Bling-bling, Fertilizer
Produces: Firewood, Lumber

Name: Builder
Bank: $5.00
Needs: Food, Shelter, Bling-bling, Lumber
Produces: Houses, Picture Frames

Name: Herder
Bank: $5.00
Needs: Food, Shelter, Bling-bling
Produces: Food, Fertilizer

Name: Painter
Bank: $5.00
Needs: Food, Shelter, Bling-bling, Picture Frames
Produces: Bling-bling

Prices for Goods (cost to make)

Fertilizer: $0.25 (free)
Food: $5.00 (free + labor)
Lumber: $5.00 (0.25 Fertilizer + labor)
Firewood: $2.50 (0.25 Fertilizer + labor)
House: $10.00 ($5.00 Lumber + labor)
Picture Frame: $2.50 ($1.25 Lumber + labor)
Bling-bling: $5.00 ($2.50 Picture Frame + labor)

Minimum requirements for life are $5.00 Food and $2.50 Firewood per year. Everything else is just quality of life improvements.

Obviously, if this is our economic universe, then all of the goods and services have to be provided between the parties keeping in mind that only $20 exist on the whole planet. If one of the parties has something that everyone wants or needs, he could jack up the price and stick it to everyone else on the planet. Conceivably, he could wind up with 75% or more of the entire wealth on the planet, and that wouldn't be fair would it? In fact, if one were to get outrageous with a price there could be civil unrest or simply a lack of customers ("I'm not paying that much for that!")

But here is the missing piece: Money is just a way of counting wealth, it's not actually the wealth itself. If money was the wealth, then even after each of our four residents marry and have children (perhaps after we import some women from Venus) there would still only be $20, but they would have to split that between 16 people (each has a family of four).

The way it really works is this:

Lumberjack has 20 trees in inventory. Over the life of each tree, he spends $.25 to maintain it. He chops down one of the trees, cuts it up into lumber, and sells the lumber to Builder for $5. Builder then builds a house worth $10. Lumberjack would like to buy the house, but he doesn't have the money. So he cuts down another tree and cuts it up for firewood. This he sells to a painter for $2.50. It's not as much as the lumber, but then it didn't require as much skill to make either. Lumberjack buys his house, and keeps providing lumber and firewood for the others. The builder builds stuff for whoever needs it. The Herder provides food for everyone and fertilizer for the lumberjack. And the artist, warm and well-fed paints a series of masterpieces that everyone wants to buy.

So far, it's your zero sum game. There can't be more than $20 in the whole world right? Except for one thing: the paintings are worth something.

And rather than their worth going down, since everybody wants one, the value of the paintings goes up, especially for the oldest ones. If one of the population gets a little cash strapped, let's say the herder wants to buy a house but doesn't have $10, he could offer two paintings (he's been feeding everyone for a while and loves the paintings so much that when he has the extra cash he buys one).

You see, it's not the money that has value, it's the stuff. And if you make stuff that people want, and you sell it for more than it cost you, you have created wealth. Money is just a convenient way to keep score.

As the population grows, and new products are introduced, and the economy grows, we need to print more money to keep track of stuff. But printing more money isn't what makes things worth more or less... it's the stuff.

Lesson 2

Governments must act responsibly when printing money. There are two worries:

1) The government could print too much money. Let's take our group of four from the previous example. If they decide to print and distribute an additional $100, while the value of the durable goods produced is only $60, they will have created an inflationary situation. The value of the stuff is still the same (think of it as "desirability" or "how much do you want it") but now you have more money so you are willing to pay more for it. The price of everything goes up to keep the relative worth the same.

The bad news here is that whatever effort you put forth to create the cash you have now is devalued.

Here is an example: Each tree as it stands in inventory has a cost associated with it of $.25 and each new tree when planted will have an associated cost of $.50 after the economy stabilizes again. Before the inflationary period, Lumberjack dude chopped up one tree for firewood and he still has it sitting in inventory. This is actually a good deal for him because he put $2.25 worth of "work" into it (for a total value of $2.50) and it is now worth $5. Cool. That's like free money. But here's the problem: just before the inflationary period, he sold two stacks of firewood for a total of $5.00 and he was planning on buying a new painting. But now the painting costs $10. His cash lost value.

2) A government can also print too little money. This creates deflation which might sound alright on the surface, but which is just as destructive as inflation. If some of the currency gets taken out of circulation by the world bank, say it goes from $20 to $10, the transition is extremely painful. What happens is this: the first thing that gets cut is salaries for the people that help you because there's not enough money coming in to pay for people. "Stuff" is still going to be the original price for a while because, as in our Lumberjack example, the effort and material have already been put into the product, and to reduce the price now means that at best you might break even or possibly even lose money. This doesn't help you pay your bills which also have not come down yet. Eventually, the sellers will have to lower prices even on their current stock just because nobody else has the cash to buy anything. If your business is strapped for cash in a deflationary period, you may well go under.

An additional drawback to deflation is that the growth of the economy will be reduced even after it stabilizes again. This is because there is not enough money to spend on durable goods like houses and paintings. It takes longer to save up enough to get them.

The key points to remember about a free economy:

1) Wealth is a measure of the value or worth of goods and services. That value is a "desirability" factor. If nobody wants it, it's not worth much even if it costs a lot to make. If everybody wants it, it's worth more, even if it didn't cost much at all.

2) Money is just scorekeeping. If tagging home plate in baseball is suddenly scored as three points, it doesn't make tagging home plate worth any more, it just inflates the score.

3) We could create a new country called Utopia and put every resident on the payroll giving everybody 1,000,000 Utopian dollars a year and we would all be living in squalor because we don't produce anything. We'd be rich in Utopian dollars, but we wouldn't be able to buy anything from anybody else because nobody else wants Utopian dollars. They have no value because nothing has been produced.

4) A free economy is not a zero sum game. If my Oakland A's score 9 runs in a game, it doesn't mean that there are nine fewer runs available to be scored by the other team. The other team might score fewer, the same, or more runs than my team. But there's no maximum score. You just need more numbers to track it.

5) Wealth is created by work. That's how an artist turns a piece of canvas and a glob of paint into a work of art; and that's how a tree becomes lumber, and lumber becomes a house, and that's also why a house is worth more than the sum of its parts; that's how an author can be paid for words.

6) Wealth can be destroyed by artificial price structures. If the government determines that the maximum price for a particular product is x, and the cost to produce that product is 2x, the only way to make that product available at x is with a subsidy, which may sound good except that the subsidy is paid with taxes and... this gives the government control of the profit margin, and through that employee salaries, capabilities for expansion of the business, research and development, etc. Likewise, if the government establishes the minimum wage at $20/hr, we'll all be paying about $10 for a Big Mac, but worse than that, unskilled workers won't be able to get a job because employers will want skills for that kind of money, employers won't offer insurance or retirement benefits because they can't afford them anymore, and taxes will increase to pay for all the new unemployment and welfare cases.

For some interesting reading with a more professional explanation of these ideas, see this essay on Ludwig von Mises.

2 Comments:

Blogger ljmcinnis said...

Nice post Bryan! Basic civics and economics is not being taught in schools anymore and when it is, the merits of socialism are heralded at the expense of capitalism. Business is always being bashed.
You might like some of Steve Forbes ideas. He was just on CSPAN speaking about Social Security and other taxes.

5:49 PM  
Blogger StevenBurda said...

Good books. Thanks.


- Steven Burda -
e-mail: steven.burda.mba @gmail.com
http://www.linkedin.com/in/burda

4:23 AM  

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