Friday, May 3, 2013

Parsimonia Essentialium

This is how an economy works:

Let's say you make a product, and it costs you $5 to make this product and it takes 1 hour to make it. Now when you sell product, you want to be able to cover the cost of production, right? So you don't want to sell the product for $4, because you'll quickly run out of funds to be able to make your product. What would be great is if you could sell it for $10, so you make back the money on the initial cost, plus pay for the cost entire of a second product.
But let's say that your product is awesome and everyone wants one. Demand is high, so you raise your price to $15, because everyone wants one. As a bonus, you're able to streamline production and make two per hour. But after a while sales dip, and demand drops. In fact it drops to almost nothing. When demand was high, you could make 2 per hour and barely get them out fast enough. Now, with demand low, even making 1 per hour causes your product to start piling up on shelves in your garage. So you drop the price to encourage demand again.

Now, a national economy (or a global economy) is a lot more complex that my example, but the principle is essentially the same. Economy is all about supply and demand and the balance between the two. What makes an economy strong is the movement of money: purchasing power. You could also call it spending. A company spends money to make a product. A customer spends money to buy the product.

Ok, so let's broaden our example a bit:
Let's say that I have the materials you need to make your product, and that's why I charge you $5. Now, I'm a bigger company than you and have a lot of customers who want my materials. So my company is making $1,000 per day, but I also have 2 employees that I need to pay by the hour for making my materials. And those employees want to buy your product.
So your money goes to me, but some of my money goes to my employees, and some of their money goes to you when they buy a product.

This is called circulation. The money essential moved in a circle (in varying amounts). On a national scale, this circle is huge and complex, but the principle is the same. People get paid for a product or service, who then pay others for a product or service, and so on and so on.
Now, I could talk about how the strength of the economy is (or should be) proportional to the strength of the middle class or the danger of credit bubbles inflating the economy with borrowed money - and both topics deserve a look - but for now, let's keep it simple and say that a healthy economy is one in which people are spending money.

So what happens when the economy is unhealthy, in what is called a recession (the movement of money slows) or even a depression (the movement of money stops)? People aren't spending during these times, so how does the economy start moving again? Companies drop the price on their goods to encourage demand, but they also have a lot of product on shelves to move before they need to increase production again, so with low demand and high supply they don't need as many employees, especially since employees cost money. So companies start trimming. But those employees need their job to make money, so they can buy stuff, which will get the economy moving again. So without the purchasing power of those employees, demand drops even further, which causes a new round of contraction and more layoffs. It's a downward spiral in dire need of a lifeline.

Enter the government.
The government can help the economy in two ways: first, it can create social works projects to create demand. Infrastructure is a great example. The government decides to fix some roads, and contracts some companies to do the job. Those companies hire workers to fill the demand, and those workers get a paycheck that they use to buy stuff from other companies, and so the economy starts moving.
Second, the government creates social programs to help the truly desperate. When a worker is removed from their job, their ability to contribute to the economy disappears. So the government steps in and assists the worker, providing an unemployment check to the worker until they get back to work again.

But what about cuts? The government is spending a whole bunch of extra money trying to help companies and workers get the economy moving. What else can it do?
Could it lower interest rates. Companies could borrow money at a lower rate, and the infusion of capital will help get their production moving. Except that only affects the supply-side of the economy, and if a company's shelves are full of unbought product, why should it make more? Does having a supply of a thing create a demand for it? Not really.

The economy moves because of spending. If consumers can't or won't spend the government has to spend for them. It's the only way out of a recession.

What worries me is that somehow many policy makers seem to lack this incredibly basic understanding of economy. We're in the middle of a global recession, and the calls for spending cuts have never been louder or more fervent.
Now, I grant you, the government could certainly spend smarter. And I grant you, the government wastes a lot of money. But if the people aren't spending, then the government has to. That's the baseline rule.

That's how an economy works.
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