Monday, January 6, 2014

On Economic Progress: Raising Standards of Living By Rick Kelo

On Economic Progress: Raising Standards of Living
By Rick Kelo

What makes economies grow?  What makes our standard of living improve?  If we want our children to live in a better, cleaner, safer world than the one we live in today then its important to understand just how we get there.  In this article I show you the exact factors that cause one nation to become a more educated, healthier, more prosperous place to live while another nation falls behind.
In order to understand economic progress I'll start by pointing out that an economy is made up of all the goods & services produced not the amount of money in a system.  This is a common misunderstanding so tuck it away as an FYI.

What makes economic growth tricky is that its based on the growth of a type of good invisible to the common man.  The things that you and I go out and buy are called "consumer goods."  They are the end products, but consumer goods also represent the minority of the economy.  Most of the economic activity takes place in a different class of goods called "producer goods."  Producer goods are the things that make the consumer goods.  You can't buy producer goods, they are sold between businesses.
Let's use a car as an example.  The value of a new car is (let's just say) $25,000.  The average car has about 20,000 parts.  Now consider all the machinery needed to make the tires, the doors, the bumper, the hood.  Most of those parts are not produced by one machine or one company, rather they are produced partially by one factor of production then forwarded to the next one.  In economics those are called "intermediate producer goods."  So along the way from raw material (known as original factors) we have numerous intermediate stages of different producer goods.  So just from that simple example you can see that to produce 20,000 parts we might have 50,000 different machines involved.  
There are 3 types of producer goods:
  • Capital Goods
  • Labor
  • Land

Each of those machines takes up land and requires labor to operate.  Land and labor are the other 2 types of producer goods aside from capital goods or what most of us call equipment (including manufacturing plants, etc).  We'll come back to them in the next section.
Now that we've considered that most of the economy is made up of producer goods its also true that most of the trade in a free market economy is trade between entrepreneurs.  B2B if you will.  Trade between entrepreneurs and consumers (consumer spending) makes up the minority of economic activity in a system.

Before we get to what all economic growth hinges upon let's use the process of elimination to remove the things that don't matter:
  1. Land & Natural Resources = the human race has no more land and no different natural resources than we had 20,000 years ago but our standard of living is dramatically higher.  The availability of natural resources has been constant over all of human history because higher standards of living don't depend on land.  Some might suggest that as technology improves we're better able to make use of these resources and we'll discuss technology shortly, but the quantity of land available is a non-factor.
  2. Labor = If you remember from above labor is the second type of producer good (land and capital goods being the others).  The ability of the human body to engage in productive activity has not changed.  You might argue its improved slightly as lifespans and nutrition have increased but those are effects of a higher standard of living not causes of it.  Knowledge is a separate factor of economic production we'll consider shortly, but when we look only at labor... at the ability of the mind & body to engage in productive activity... it hasn't changed much if at all over human history.  You are capable of working as many hours in 2013 as your caveman ancestor was in 20,000BC.  In fact you probably work less...
  3. Technology = Firstly what is technology?  It's a specialized type of knowledge.  Knowledge in general is just ideas and ideas are easy to formulate.  Technology is the knowledge of production.   Remember at the start of the article we discussed what an economy is: the sum total of all the goods & services produced.  In order for technology to increase production it must be embodied in capital goods (equipment, manufacturing plants, etc).  Capital goods are difficult to produce, ideas are easy.  The reason technology doesn't increase the standard of living is that its not ideas themselves that lead to economic progress, its the embodiment of those ideas in new techniques used in production.

Just a few things things:
  1. Time preference = When you hear economists arguing about interest rates and the Federal Reserve tinkering with interest rates this is why.  The interest rate isn't just an arbitrary number you can make up.  In free market capitalism it tells us what people's time preferences are.  The shorter the time preference in a society the more growth can occur and the more quickly the standard of living increases.  This happens because with lower time preferences there is more saving and investing.  (Investing in this case means spending money on new machinery, factories, and other factors of production).  So when there is proportionally more income being saved/invested there is less going to consumption.  This means there's more capital formation, therefore more achievements in increased productivity, and that gives us higher standards of living.
  2. Capital Goods = This one has been conclusively proved by different economic studies over the last half dozen decades.  If we raise the quantity and quality of capital goods it raises the standard of living in every instance.  Capital goods are the class of producer goods used to make final consumer goods you and I either buy at the store in the case of a good or consume in the form of services like the music we listen to, etc.  How do we increase the quantity and quality of capital goods?  Well some of that is done through a process called "capital accumulation."  Our capital stock has increased exponentially over time.  I don't think any of us could picture how poor and destitute America would be if we had the same amount of capital in the country today that we had in 1913.
  3. Entrepreneurship = In order to not squander the valuable resources we have its necessary to economize.  The entrepreneur performs the function of economizing for society as a whole by reallocating resources away from less desirable lines of production and into more desirable ones.  Society has to make decisions about different types of producer goods... is it wiser to build a new distribution center or new medical office space?  That decision is impossible for you or I to make because we will never specialize in both fields.  So in division of labor economies like ours its the specialized entrepreneurs in those industries who make the economic calculations for society as a whole.  Its the accuracy of their entrepreneurial foresight that allows us to make better use of producer goods, and the better use we make the higher our standard of living becomes.
  4. Private Property & Contract law = These are foundations of capitalism and the free enterprise system.  It also so happens that their existence & the amount of protection they enjoy greatly accelerates the increase in standards of living.  Private property being legally protected and contractual arrangements being legally protected allows the capitalist system to function because it enables things in the market to self-select based on efficiency instead of based on other coercive factors.  For this reason you can pretty much go right down the Economic Freedom Index and you'll notice its rankings line up almost identically to all the different standard of living indexes like the UN's Human Development Index.

How do we know that capital goods make up the majority of the economy?  How do we know the majority of transactions that take place are between entrepreneurs?  
This is an important point because some of the flawed, older schools of economic thought like Keynesianism don't take this into consideration.  Keynesian economics posits that recessions are caused by decreases in consumer demand & if the government puts more money in the hands of people that increased spending is all it takes to fix an economy.  We know that is untrue because the economic drop during a recession is mostly due to changes in investment not in consumption.  Think about the "Great Recession."  That recession occurred due to bad investment decisions in the housing market, it had nothing to do with consumer spending.  How about the recession before that, the "Dot Com Bubble?"  Also investment changes caused the contraction.
This happens because consumer spending makes up the minority of any economic system.  The purchase of producer goods from one entrepreneur to the other is what we must encourage at all costs because this is the majority of the economic activity in a system.  The economy is like an iceberg and the things you and I can purchase are only the tip above water.  Here's an example using a simple economy:

This is a simple two-stage economy.  The real economy is hundreds of layers deep with only the lowest stage of the production process sells a good you and I can purchase.  So in our simple two-stage economy Company A produces something you and I buy.  Company B&C produce intermediate goods & Company Z produces capital capacity.  So suppose Company A is a fast food restaurant.  If that were the case then let's just say Company B sells the various paper products like soda cups, french fry cups and brown paper bags.  Company C sells goods needed by Company B to make this product.  So maybe Company B has the mills to make paper bags but buys all its cardboard for the 4 cup soda holders from Company C, and so on and so forth.
If we assumed that whole economy above was a nation this is what its national account would look like:

Notice the Net Rate of Return is not the same across all industries.  Economists would say there exists an arbitrage opportunity for entrepreneurial foresight to come into the highest profit area (the one Company Z occupies) and shift resources / capital investment from a lower profit process and acquire a gain.  An entrepreneur will come in and compete with Company Z by redirecting money that otherwise would have gone to, say, Company C in a lower profit industry.  This will happen until the goods Company C produces become scarce and their profit level rises while the profitability of Company Z's industry declines with the supply created by the new entrepreneur reducing prices.  Eventually all 4 industries will settle in at a 4.875% Net Rate of Return and the market will reach equilibrium.
Last point, suppose we tallied up the Gross Income & Gross Expenditures for our sample economy.  Gross Income is the sum of the goods produced plus the value of the original factors / raw materials.  In this case Gross Income = $10,000.  Gross Expenditures that balance against this are the sum of consumption and Gross Investment so $2,800 + $7,200 = $10,000.  You can see that investment is 72% of this economy and consumption is only 28%.  

Any advanced economy with hundreds of stages of production will always end up with a gross saving and investing that far exceeds consumption, and that is why when there's an economy wide problem it always comes from Gross Saving/Investing since it is 3/4 of the economy not from consumption which makes up the small minority.  This is exactly what we saw in the Great Recession pictured to the left.

This one is kind of a no brainer, but I felt I'd discuss it.  Most of us want the world to be better for our children than it was for us, and we want them to have more opportunities.  We often don't consider that with the increasing population its necessary for our standard of living to increase at at least the same rate in order for the country not to be retrograding.  Still, when this topic comes up invariably it flushes out a few morons.  So do we want an increasing standard of living and what benefits come along with that?
Some of the benefits include access to goods that didn't exist previously or were only luxuries of the very wealthy a generation prior.  Then there's the longer life-span, better access to education, lower unemployment, more vacation time per year, less poverty, safer workplaces, cleaner environment, and so on.  Like I said, pretty much a no-brainer that we'd all prefer those outcomes to the opposite.
Not so for those who oppose economic growth & progress.  
You will, from time to time, hear socialists reference wanting a "sustainable" society.  When you ask them in more detail they will tell you that "sustainable" is going to involve having to kill off a lot of people.  This is, of course, consistent with what we've seen in the real world as well, but lest we forget: in the socialist experiment known as the "Great Leap Forward" Chairman Mao killed off so many Chinese we're not even sure the real number.  Historians put it somewhere between 40 million & 70 million of his own citizens.  While implementing his "socialism in one country" policy Stalin killed off (again a partially unknown number) around 20 million of his own citizens.  Now as someone who morally opposes the use of force I have a problem with this.  Socialists do not, but saying you favor a "sustainable" world sounds better than saying you favor a world with 1/4 less people in it, more dangerous workplaces, greater starvation, and more poverty yet those are precisely the conditions that developed in the socialist "utopian" nations like the two mentioned above.
I, for one, would prefer to live in a growing & expanding society where everyone's overall standard of living improves.  If you would as well then anytime you hear a socialist tell you they'd prefer a "sustainable" society to a growing one your ears should perk up.

What do we take away from all this?
If we want a higher standard of living we must pursue the policies that best protect entrepreneurship, and we must jealously guard private property rights from attack.  

Entrepreneurship = it is necessary for entrepreneurs to make a profit in order for them to save and invest.  The more profit they make, then all other things being equal the shorter time preferences become the more saving/investing occurs.  It is that saving that funds not only research & development but also allows us to take advantage of new technologies as they come available.  Its not enough for us to discover a technology, in order for society to benefit from it we must have money saved to capitalize on the new technology by adding it to the production process as a new capital good.
Private Property Rights = the largest quantity of attacks on private property rights comes not from vikings, or marauders, or corporate enemies, but from government.  Government has no money of its own, every task it sets out to do is paid for by someone else in the economy.  If government grants farm subsidies (like I discuss here) it can forcibly restrict domestic production, or forcibly prevent foreign imports.  The higher prices on the farm products though are paid by you and me at the cash register not by the government.  If government decides to improve the conditions of some workers by increasing the power of union compulsion the state doesn't pay those higher wages.  Those higher wages are paid by higher unemployment and the overall real wage returns to the market's equilibrium.
Continued; you can access part 2 by clicking here: On Economic Progress: Sustainable Capitalism & Bubbles 

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