First principles on wealth and economic growth

Shanghai – Before and after

In all human history there have been just four ways of securing the goods, services, or the wealth to purchase them, required to maintain life or a desired standard of living.

First, we can receive them freely from others as gifts or charity. Second, we can take them from others as theft or tax. Third, we can borrow them from others with the promise of repayment in the future. And fourth, we can receive them freely in exchange for a good and service we provide in return.

It is clear that the first and second methods depend entirely on someone else producing the good or service in the first place. You cannot be gifted or steal what doesn’t exist. These methods are purely redistributive and add nothing to the available stock of goods and services, the increase of which is the essence of economic growth and increasing wealth.

Method three, borrowing, is fine as long as it is used for investment to increase the stock of goods and services out of which it will be repaid. The fourth method, free production and exchange, is best of all. People secure the goods and services needed or desired by exchanging those they produce for those produced by others. People’s desire to consume more induces them to produce more. The stock of goods and services available, society’s wealth, increases.

All societies engage in a mixture of these methods, different sections of those societies relying on different methods at different times. But it is clear that societies which rely to a greater extent on the first and second method are, at best, shuffling round a stagnant stock of goods; not creating wealth but merely redistributing it.

Societies using more of the third method could be acting wisely if they are borrowing to invest, but if they are just borrowing to fund current consumption then they will be paying this back out of the same (or smaller) stock in the future. Societies more reliant on the fourth method will be increasing their wealth unambiguously.

So we can say that if the aim of society is to increase wealth it ought to be utilising lots of the fourth method, the third method only to fund investment, and the first second method as little as possible.

This throws stark light on the shift in relative wealth going on in the world today. Wealth is increasing in Asia in part because relatively large proportions of their populations are producing things people want to buy. And, in part, the wealth of the western economies is stagnating or declining because, relatively, we have a greater share of our populations receiving the goods and services they need and desire (or the wealth to purchase them) as transfers from others. We see ever more borrowing to finance current spending and ever more redistribution of wealth at the expense of its creation.

If a country has a great many goods and services available it is wealthy. If individuals are able to command a great deal of goods and services they are wealthy. The nature of increased wealth is an increased number of goods and services. The more people we have producing them and increasing this number, as in Asia, the wealthier we will be.

This article originally appeared at The Commentator

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The economic reality of 2012

We’re doomed!

Going into 2011 it was still possible to find economic optimists. The Office for Budget Responsibility predicted relatively perky growth of 2.1 percent for 2011 and why not? The OBR had just revised its growth figures for 2010 up to 1.8 percent from its previous estimate of 1.2 percent.

A year on this looks like an economic wonderland. In November 2011 the OBR forecast growth for 2012 of a paltry 0.7 percent following just 0.9 percent in 2011 compared to that 2.1 percent forecast a year earlier.

What does this teach us? One lesson we should take is to be wary of the forecasts of economic ‘experts’.

One lesson we shouldn’t take is that the answer is more Keynesian stimulus of the kind that generated those growth rates of nearly 2 percent in the halcyon days of 2010. For one thing, that growth came at the expense of a deficit of 11 percent of GDP, or a borrowed £147 billion.

And it didn’t work. Of course a vast infusion of borrowed cash will bump up GDP figures, they measure spending in an economy as a proxy for measuring real economic activity. But the thinking behind stimulus spending is that it stimulates the economy to get back on track. That the economy slumped when this stimulus was removed proves that it failed.

It failed because the problem is not the exogenous drop in aggregate demand of Keynesian folklore which must be compensated for by government spending. The problem is the thoroughly endogenous one of debt. It is because people are paying for yesterday’s consumption that they are cutting back on today’s. Simplistic non-solutions based on the Keynesian misdiagnosis will continue to fail.

So what can we expect for this year? If we accept that the problem is not simply a lack of “animal spirits” but one of debt both public and private (or private debt made public) a grim prospect emerges.

There are two ways of dealing with debt; you can pay it back or you can default and not pay it back. Within the default option are two sub options; you can default overtly and simply refuse to pay your debts, or you can default covertly and pay the debt with devalued currency.

Prospects in the eurozone, the current nexus of the financial crisis, depend on which of these paths is followed.

There are countries loaded with debt like Greece, Italy or Ireland, and those like Germany which aren’t. The choice will be, as elsewhere, whether the indebted countries repay or default. An overt default would mean an indebted country simply refusing to pay its debts leading to exit from the euro. A covert default would mean paying debtors back with a devalued euro, inflation, in other words. There is widespread opposition to the first and German opposition to the second and German opposition is all the opposition that counts.

That leaves repaying the debts in full. With Germany unwilling to help out in the form of eurobonds the full burden falls on taxing and spending measures in the debtor countries. The question for 2012 is whether these fragile economies can take the drastic fiscal tightening necessary. If they cannot and if Germany holds to its current position we go back to the option of overt default and break up of the euro.

Other countries are using a mix of fiscal and monetary policy, or repayment and default, to deal with their debt burdens. Britain’s spending cuts are more imaginary than real and much of the reduction in British debt is being done by inflation which has been above the Bank of England’s target since December 2009.

Between these scissor blades household incomes will fall or, at best, stagnate in Britain in 2012. GDP will do likewise providing the eurozone does not collapse. But given Britain’s debts it would be folly to think that any other government with any other program could produce a better result. As bad as it is, it’s as good as it gets.

Another country which has been using the printing press to ease its debt burden has been the United States. With its combination of eye watering deficits and low interest rates the US been held up by Keynesians as proof that deficit spending can be sustained.

In truth its unique position as issuer of the world’s reserve currency gives the US the ability to produce vast quantities of dollar denominated securities without seeing its borrowing costs rise.

But problems deferred are not problems avoided. In the long term the US deficit will have to be brought down. This will become more of an issue through the year as November’s election approaches.

In the shorter term the danger is of a dollar dump. The continuing decline in the dollar’s value will continue to trouble investors in China, the Gulf and elsewhere who are holding dollar denominated debt. This is behind the intermittent skirmishes which have become known as ‘Currency Wars’. Will these erupt into full scale war in 2012 as investors dump their dollars and inflation results?

It’s unlikely. This is not because of any strength in the US economy or policymaking but simply because everywhere else is worse. Adam Smith said that there is much ruin in a nation and there is a little more ruin left in the United States.

This is a very western-centric analysis and thus incomplete. The problems China faces as it tries to reign in the effects of its credit boom require a separate article. But increasingly global economic issues will be framed by the likes of India and Brazil. Countries such as this face problems and are less homogeneous than the famed BRIC acronym suggests. But as the west struggles under its crushing debts the continuing rise of economies elsewhere could be the real story of 2012.

This article originally appeared at The Commentator