On Economic Progress: Sustainable Capitalism & Bubbles By Rick Kelo

On Economic Progress: Sustainable Capitalism & Bubbles
By Rick Kelo

This is a companion article to On Economic Progress: Raising Standards of Living.  

In this article I am going to show you what a sustainable capitalist economy looks like, and why unsustainable things like bubbles happen.  First we should consider that its not consuming that's good for an economy, what matters is producing.  This is because an economy is not made up of all the money in a system its made up of all the goods & services.  Keep that in mind as we look at how economies grow and what forms these "bubbles" we all hate.  First to recap from the first article we discussed:

• The two main types of goods: consumer goods (the things we purchase) and producer goods (the economic infrastructure, like factory machines), that creates the consumer goods.
• The three types of producer goods: land, labor & capital goods.
• The economy is like an iceberg: consumer goods are the minority portion above water, producer goods make up the majority of the economy.
• Things that increase standard of living in an economy include: time preference, capital goods, entrepreneurship & a legal structure that protects private property and, by extension, contract rights.
• How we know recessions are caused by changes in investment in an economic system not changes in consumption.

From that list let's look in more detail at capital goods & at time preferences and answer the question: how do we achieve faster economic growth?  Simple: the more savings taking place in an economy the faster it will grow.  That's the how, but its in the why where the interesting stuff lies.

The Final FrontierHalf of you heard that phrase and thought Star Trek, the other half heard it and thought Iron Maiden.  Well you're both wrong!  Today its economics and the name of the game is the Production Possibility Frontier = 

(PPF from here on out).  This is a basic concept covered early in economics, and the idea is that if we have two things competing for the same resource the possible outcomes of which side gets what amount can be graphed.  In microeconomics we might look at two rivalrous goods and ask how we decide how many snowboards vs skis are purchased each month.  In macroeconomics the curve is used to look at the production of producer goods (specifically capital goods) vs. consumer goods.  

Remember that consumer goods are the things you & I buy and consume.  For these graphs think of consumer goods in relation to "consumption" and producer goods in relation to "investment."  Those are the terms that give us the GDP formula of GDP = C + I + G + NX.  C & I are consumption and investment.

If you'd like to play around with an interactive PPF click here.  

Investment Defined:One piece of confusion to dispel: in economics "investing" means spending money to buying a new capital good.  So a business "invests" in a new machine to make its product or in another type of expansion.  This form of spending rivals spending on consumer goods, but its important to understand why.  When we "invest" in an economic sense an entrepreneur is making the decision to delay producing a consumer good he could sell today in return for being able to produce more or better quality consumer goods for you to buy in the future.  Investing differs from saving done by individuals, which is delaying present consumption in return for future consumption (like saving for retirement).

Robinson Crusoe Invests in His EconomyConsider the entrepreneur's decision to produce either goods for consumption today or to invest in new equipment that will produce even more in the future.  As an analogy picture Robinson Crusoe alone on his island.  He has two choices to gather food.  On the one hand, he can go fishing by standing in the water up to his ankles and catching fish that swim by.  His other choice is make a capital good, or maybe several layers of intermediate capital goods even.  Suppose that Crusoe first makes an axe out of a rock & stick.  This is an intermediate capital good.  Crusoe then uses that axe to cut down vines (another).  He then weaves those vines into a net (another capital good).  Finally he uses that net to catch fish for consumption (his consumer good).  Crusoe made the decision to delay current the production of fishing in knee-deep water and instead "invested" his time in making several stages of capital goods with the expectation that he'd catch more fish in the future.

This is the exact decision entrepreneurs & people make.  Graphed on the PPF that decision looks like this:

The Pencil
From looking at the graph above its probably not too obvious why economic growth is greater when we save / invest more.  There's one factor that isn't yet included in the graph above though.  Remember the very simple two-stage economy from the last article? (viewable here)  Well the actual US economy is made up of tens of thousands of intermediate stages of production.  

Just a simple pencil probably has 50 stages of production if you think about it.  We use capital goods to harvest the raw material of wood, transport it to a mill, process it into a pulp, move it to a pencil factory, then finally process it into pencil form.  There is a lot of very expensive equipment involved in those 6 stages of production and there are another 5 (or more) for the graphite, 5+ stages of production for the paint, 5+ stages for the tin that goes into the metal end, 5+ stages of production for the rubber in the eraser, 5+ stages for the packaging and so on (we haven't even gotten to the distribution and retailing).  If we tried to model a pencil we'd have easily over 50 stages of production and hundreds of millions of dollars in capital goods, like equipment, along the way.

What isn't included in the simple graph in the section above is that capital goods break down as they're used.  Machines have to be maintained, and in order for the economy not to shrink we have to invest a certain amount of replacement capital.  So we only get more goods in the future if we invest at least enough money to cover replacement costs of maintaining our existing stock of capital goods, and then some.  

Here's how those two graphs look with an identical cost of replacement capital included:

The Effect of Saving & Investing
Now you start to see the difference that it makes to an economy when we have more saving and investing taking place.  The real effect becomes obvious when we add on the net investment created in Preference A compared to greater net investment caused by more saving/investing in Preference B:

How Bubbles FormWhat do you imagine happens to investment versus consumption when the Federal Reserve alters the interest rate?  Let's take a look.  To do this I'm going to take you into another economic theory called Loanable Funds theory.  Its really simple: the amount of money saved in a bank sets the amount of money available to be loaned out.  

(See told you it was simple).

In effect the entrepreneurs in society take control of unconsumed resources and use those to add to the productive capability of the economy (this is what economic growth actually is).  To the left is the loanable funds graph.  Its a basic supply & demand graph for interest rates.  When people decide to save more the supply line shifts to the right and the interest rate falls to the second interest rate shown in blue.  If there's more saving taking place, then banks have more money available to loan and don't have to offer as high an interest rate.  On the other hand, if you're a banker and you don't have enough money to write loans then you will raise the interest rate to entice people to save money at your bank.  The same movement in interest rates holds true for loaning money out.  If you're a banker and have a lot of money to loan then to attract entrepreneurial investment you lower the interest rate.  In other words no different than any supply/demand curve: when the supply is high the price goes down.

This exact dynamic accounts for most of the problems we run into from the Federal Reserve.  When entrepreneurs see low interest rates they assume there's a lot of saving taking place.  That makes it a good time to invest in new capital goods because when that improved future production arrives consumers will have the saved money to spend on your product.  The PPF and loanable funds graph overlay and show how the whole process SHOULD come together.  Lower interest rates lead to more saving, which SHOULD only be able to be caused by less consumption taking place:

Above (if you look from the bottom PPF and follow upwards to the loanable funds curve) you will also see our proof that when people save more the interest rate falls.  We already know from Figure 4 that this increased savings also produces greater economic growth.  This happens because entrepreneurs, attracted to the lower interest rates, borrow more and underta

ke new investment projects in capital goods.

How the Federal Reserve Screws It UpIn an unhampered market economy the interest rate is arrived at just like any other price in the market: supply, demand, equilibrium point and PRESTO price (or interest rate in this case).  However not so in America in 2013.  Today the interest rate is arbitrarily decided by government appointees.

After 6 years of slogging through Alan Greenspan's Great Recession this one shouldn't come as much of a shock to anyone, but the Federal Reserve knocks the whole process above out of equilibrium.  Below is what happens when the Federal Reserve tricks entrepreneurs into making more investments than they should while also tricking consumers into consuming more than they should.

On our Loanable Funds graph what the Federal Reserve does is lower the interest rate to make entrepreneurs think more money is being saved and, thus, that its a good time to invest in new capital goods.  The new artificially lower interest rate at Point 2 causes more entrepreneurial demand for loans to fund investment because now money is cheaper (Point 4).  That's why Greenspan's policies were called "easy money" policies.  The catch is that because no actual additional savings took place to cause that lower interest rate the S1 curve in the graph hasn't really moved, it only appears to entrepreneurs to have moved.  When consumers see the lower interest rate they save less because saving is now proportionally less attractive and move down the real S1 curve to Point 1.  Since you can only save or consume that move to Point 1 also means consumers are spending proportionally more of their money, and on the Production Possibility Frontier are actually at Point 3 when entrepreneurs think they're at Point 4.  This is what happens:

And that, ladies and gentlemen, is how you get a (housing, dot com, credit) bubble.

Policy ImplicationsRemember the PPF is a frontier so changing preferences or decisions move the point along the frontier.  People may feel at one time that they need to be saving and at another time feel the need to consume for a lot of reasons.  Some are demographic reasons like an aging population approaching retirement.  The main factors though are inflation and interest rate changes with tax policy next in line.

When economists talk about inflation its common to hear one say it "destroys economic growth", but why?  It all has to do with the Production Possibilities Frontier above.  Inflation is one factor that changes people's preferences to consume versus save/invest.  After World War 1 the German Wiemar Republic had some serious hyper-inflation.  Workers were paid three times / day, then would give that money in suitcases to their wives to run out and purchase anything they could.  When you're facing 7,200% inflation there's obviously no reason for saving.   Now consider average inflation in America.  In 1933 FDR took America off a true gold standard.  In the 50 years prior to 1933 (so from 1883 - 1933) inflation averaged 0.58%.  In the next 50 years (so from 1934 - 1984) inflation averaged 4.18% (Source).  Put into proportion inflation has been 721% higher following the removal of the gold standard than it was before.

Interest rates we've already covered above so that leaves only tax policy.  Taxes on entrepreneurs reduce the amount of money available to invest in new capital goods.  Remember that graph in Figure 4?  Higher taxes reduce the new "net" investment each year by redirecting that growth out of the economy and into the government.  In the period from 1813 to 1913 federal government spending averaged 2.89% of GDP (Source), and the US economy grew at an average rate of 3.97% (Source).  In the last 100 years of big government from 1913 to 2012 federal government spending averaged 17.1% of GDP (Source) and the US economy grew at an average rate of 3.26% (Source).  That difference of 0.71% or 18% less growth each year turns out to be a pretty big deal.  If we'd instead gotten the better growth we had when federal spending was restrained the US economy would be double the size it is today (203% of its present size to be precise).  That difference between having the $15T economy we have today and having a $30T economy would have made the word unemployment disappear from the American vocabulary.  But that 17.1% of GDP is only federal government spending; state government spending has exploded too.  Today total government spending accounts for 39% of the American GDP; I'd say its time we redirect that growth back into the economy.