Finance

How the Economic Machine Grows and Why it Crashes

By May 7, 2020 May 19th, 2020 No Comments
11 min read

Understanding the economy isn’t just for governments, financial institutions, and bankers.

It affects all of us.

In fact, the majority of the money in the economy is made up of everyday people’s pensions. That is OUR money, OUR future, OUR retirement dream of owning a farm with our partners, families, maybe a few SUPER CUTE Aussie Shepherds.
Australian shepherd dream
During the 1930 – 1932 market crash, $1 dollar in your pension/investment fund, after 2 years, suddenly is only worth $0.13 dollars ($12.9 cents) [source: Fed Reserve Bank St. Louis]. In other words, if you’ve worked your butt off for 40 years to save up $1,000,000, it’s value would have shrunk to a mere $129,000 in just 2 years. Worst of all, it stayed that way for the next 20 years…

Most of us know something is happening with our economy, our jobs, our future. But we don’t know what to do until it is too late…

As I’m going through my first financial crash as an [educated] adult, I thought the best way for me to contribute to the world right now is to share my studies and thoughts on what is happening, why it’s happening and what we can do to come out better on top.

While the spark of this crisis is due to the COVID-19 global pandemic, the real reason for the crash is because of something else. To best illustrate this, I’ll condense things down into first principles and sketches.

I wish this is something I’d studied as a kid going through school. Special thanks for Adam Smith, Ray Dalio, Warren Buffet, Charlie Munger, Peter Schiff, and Naval Ravikant who have taught me so much by writing and sharing their wisdom.

The island in the story I’m about to tell is inspired by my love for… Bali.

May 7 2020

Story

Once upon a time, there were three people – Amy, Benny, and Charlie – who lived on an island alone. The island was a rough place with no luxuries. Food options were extremely limited. The menu consisted of just one item: chicken.

The island was surrounded by an abundance of a strangely homogenous population of chickens. Any one of these chickens was large enough to feed one human being for one day.

However, this was an isolated island where no human technology was yet available. So the best way for everyone to eat is to chase and catch a chicken every day by hand.

Using this inefficient technique, each person was able to catch one chicken per day, which was just enough for them to survive to the next day. This activity amounted to the sum total of their island economy. Wake, hunt, eat and sleep.

This is a super simple, chicken-based economy where there’s

  • No savings
  • No credits
  • No investments

Everything that is produced is consumed.

In order to improve their lives beyond their subsistence level, the island tribe realise they need to catch more than one chicken a day.

One night, Amy ponders the meaning of life, asking: “Is this all there is?” Suddenly an idea formed in her head – she needed a device that vastly increases her reach to catch a chicken. She set out to find the materials to build one. She decided to call this device a “spear”.

The next day, Benny and Charlie realised Amy wasn’t focused on hunting. After asking Amy about her idea of building a spear to “revolutionise the way they catch chicken”, they both rolled their eyes and thought their friend had lost her mind…

Determined Amy keeps on sharpening a long piece of wooden stick.

By the end of the day, Amy has created her spear. She has created capital by taking on risk, underconsumption, and making sacrifice.

That night, while Benny and Charlie slept with full stomachs, Amy dealt with hunger pangs and physical exhaustion. Still, she’s hopeful that she’s done the right thing and is motivated by a bright, chicken-filled future.

………

The next day, Benny and Charlie made fun of Amy’s invention. Undeterred, Amy charged into a nearby garden. Ridicule kept coming as she awkwardly handled her strange new device.

After a few minutes, she got the hang of it and caught her first chicken. Benny and Charlie stopped laughing. Amy landed her second chicken within her next hour of hunting. the boys were in awe. After all, it generally took them all day to get just one chicken!

From this innovation, the island’s economy was about to drastically change. Amy had just increased her productivity, and that was a good thing for everybody.

Amy pondered her sudden boon. “Since I can provide two days of food with only one day of hunting, I can use every other day to do something else. The possibilities are endless!”

First Principles

Underconsumption
In order to build her spear, Amy is unable to hunt for that day. She has to forgo the income (one chicken) that she would have otherwise caught and eaten. It’s not that Amy lacks the demand for chicken. In fact, she loves chicken and she will go hungry if she doesn’t get one that day. But she is choosing to defer that consumption in order to potentially consume more in the future.

Risk-Taking
Amy is also taking a risk because she has no guarantee if her idea of a spear will work, or allow her to catch enough additional chickens to compensate for her sacrifice. If she had failed, she would have starved and would expect no compensation from Benny and Charlie.

Capital
In economics, capital is a piece of machine that is built and used not for its own sake, but for building or making something else. Amy doesn’t want the spear, she wants the extra chickens the spear brings. Therefore, the spear is a piece of capital. It’s a machine that allows her to catch more chicken per day.

It’s valuable.

Productivity is King
The simplest definition of economics is the effort to maximize the availability of limited resources to meet as many human demands as possible. Just about every resource is limited. Tools, capital, and innovation are the keys to this equation.

By doubling her productivity, Amy is now able to produce more than she needs to consume. From her gain in productivity, the benefit will flow to all others in the economy. Her willingness to take a chance and go hungry led to the island’s first piece of capital equipment, which produces savings (for this story, let’s assume her chickens do not spoil). This saving is the lifeblood of the economy – not consumption.

Keeping this in mind, it is easy to see what makes economies grow: finding better ways of producing more stuff that humans want. This doesn’t change…no matter how big an economy eventually gets.

Wealth Is A Positive Sum Game

20 May 2020

Story

After witnessing the ease with which Amy now catches her chicken, Benny and Charlie ask her to share her innovative chicken spear.

However, Amy remembers her self-sacrifice. She remembers their ridicule and thought of the risks. “What if they break my spear? What if they don’t give it back? Then it’s back to square one for me”.

Although Benny saw the effectiveness of using a spear, he was uncertain about building it himself and unwilling to take risks. After all, if he fails, he might starve to death.

Charlie feels the same way. He stepped forward with another proposal for Amy to lend them her surplus of chicken. That way, they can take the risk to make their spear, without the significant downside of starving to death. The pair promise to repay every chicken they borrow from Amy from the extra chickens they’ll catch in the future.

The idea appeals to Amy more than giving away her spear, but she was still very sceptical. Amy’s still taking on risks by giving away her extra chickens with no extra benefits to her.

Benny and Charlie conceded. They realised they were asking Amy to take a risk for no personal gain. But the possibility of an extra chicken a day was too strong to pass up. They crunch the numbers and come up with a plan that will interest Amy.

Benny proposed to Amy, for every chicken she lends them, they’ll pay back two. A 100% profit.

Amy is now interested.

To some, Amy may be a blood-sucking vampire and appears to have crossed the line. However, that isn’t true. Even if Amy intends only to benefit herself to satisfy her greed, it will provide a benefit to the world that would have otherwise been unavailable.

It’s crucial to note Amy does not need to make the loan. She has plenty of options:

  1. She can save what she has saved for future use. It’s the safest, but her savings wouldn’t grow.
  2. She can consume what she has saved.
  3. She can invest what she has saved by building another innovation, such as a bow and arrow, that further increases risk with an uncertain return.
  4. She can lend out what she has saved. She’ll make a profit through interests. But there’s always some risk that she won’t get her chicken back.
  5. She can try a combination of the above four options.

four use of savings in an economy

Ultimately, Amy’s decision will be based on her desire between risk and reward.

In the end, Amy decides to make the loan.

As a result of Amy’s willingness, and ability to make loans, Benny and Charlie now have spears that they didn’t own before. With spears available to all, the island’s collective chicken catching capacity has been raised from three chickens per day to six chickens per day. The economy has doubled in size, the future looks brighter for everyone!

First Principles

Increase In Consumption Doesn’t Grow The Economy
The economy didn’t grow and become wealthier because three islanders were unsatisfied and demanded more out of their limited lifestyle.

Demand for more is natural to all humans. No matter how much we have, we always want more. We want more stuff, more time, more fun, more choices. However, this requires more capital.
Our islanders have probably been hustling for their one chicken per day for years, wanting more. However, nothing has changed. In the end, the only way to meet their demands by expanding productivity.

The economy didn’t grow because they consumed more. They consumed more because the economy grew.

This is a simple concept however, modern-day (Keynesian) economists often confuse this and think that demand can be increased by giving people more money to spend. Only by increasing supply (productivity) can people get more of what they demand.

Wealth
Wealth is the ownership of machines (capitals). A lot of times, we define a person’s wealth based on how much money they have. However, that isn’t all there is. A better way to define wealth is through the total value of capitals a person owns.

Capital has leverage. Leverage means one unit of your input will result in more than one unit of output. You’ll always expect the profits to be higher than the cost. Capitals with leverage allow an individual to produce more than what they did before.

The best form of capital is the one that works while you sleep. For example: creating an online product that makes money while you sleep, investing in companies that are growing passively, employing efficient people to work for you are all modern-day examples of wealth creation.

Wealth Is Relative
Wealth is always relative. When I’m having a bad day, I often eat out at a restaurant. It reminds me of how wealthy and lucky I am. Because looking at the plates of fish, chicken curry w/ veg and rice, I know even the wealthiest emperor couldn’t have what I have as often as I could have it.

In a primitive society where little is produced, even the richest can’t match the material well-being available to the poor of an industrialised economy. The mightiest kings lacked the basic amenities that nearly everyone in our society takes for granted. Things like air-conditioning, medicare, toiletries, plumbing, and fresh fruits in winter.

Wealth Is A Positive Sum Game.
To some, it may seem that Amy is taking advantage of her needy neighbours. The varying degree of wealth in our society has always struck some as being inherently unfair. Central to this is the belief that the rich become that way because they take wealth from others, thereby creating the poor. In modern economics, some labelled this idea “the labour theory of value,” which states that profit is created by paying workers less than they are worth.
This idea has nothing to do with reality. The reason that the rich get that way (at least initially) is that they offer something of value to others. In any entrepreneurship, you only profit because the goods or services you provide are valuable to others.
The only way for Amy’s (or any wealthy individuals’ and corporations’) savings to grow (without working themselves) is to make it available to other members of the community, why would they hoard it?

Charity Can Demote Economic Growth
Let’s imagine Amy, feeling guilty about her wealth, was convinced to give away her chickens for free. What would Benny and Charlie do with the extra chicken?
Without the burden of repayment, they would most likely use the gift to increase their leisure time. While there is nothing inherently wrong with leisure (in fact, it is the goal of most human activity), Benny and Charlie’s vacation would not increase the island’s productive capacity. Their happiness would be short-lived.
While the charity option sounds more magnanimous and may improve Amy’s (or a particular political leader’s) popularity, it doesn’t provide the economic boost that a business loan would.
The bottom line is that anything that leads to more chicken catching (production) benefits the island. The more chicken there is, the more possibilities there are for everybody to eat more, do something besides hunting, or perhaps, do nothing at all.

Capitalism Is Good When Every Party’s Self-interest Is Allowed To Flourish
Capitalism is inherently good because it aligns the incentive of the haves with the have nots (the rich and the poor).
Any lender can only benefit only if the borrower benefits.
However, this turns bad if it’s done in an economy where people’s free will isn’t respected.
If Amy obtained her wealth by stealing half of her neighbours’ catch every day, then it would be true that her relative wealth would be derived from the relative poverty of those she oppresses.
Actions that involve forcing others to do something against their interests would not increase the island’s overall productive capacity. More likely, the total size would fall. The oppressed would cut back on their work when they realised the fruits of their labour would be stolen.
Large-scale examples of such coercion dominate history. Slavery, serfdom, and peasantry all come to mind.
Unfortunately, examples of large-scale economic freedom are rare in global history. But when self-interest is allowed to flourish, productive capacity expands quickly.
As long as lenders and borrowers are free to strike their own terms, the collective results will be a success. However, as we will go through later on, the market for loans can be distorted by outside forces. When it is, disaster usually follows.

Data Storytelling

All convincing theories and hypotheses are only complete with some data. I think one of the best examples from modern history that best illustrate this is the growth of China in the last 50 years. [Source: Congressional Research Service]

China’s rise from a poor developing country to a major economic power in about 40 years has been amazing to watch. From December 1978 (when the Communist Party adopted Deng Xiaoping’s economic proposal that began in 1979) to 2017, according to the World Bank, China has “experienced the fastest sustained expansion by a major economy in history—and has lifted more than 800 million people out of poverty.” [Source: World Bank 28 March 2017]

China’s Economic Growth Before Reform
Before 1979, China maintained a centrally planned economy. A large share of the country’s economic output was directed and controlled by the state, which:

  • Set production goals
  • Set controlled prices
  • Allocated resources throughout most of the economy

By 1978, nearly three-fourths of industrial production was produced by centrally controlled, state-owned enterprises (SOEs), according to centrally planned output targets.

Since most aspects of the economy were managed and run by the central government, there were no free-market mechanisms (savings, loans, interests, ownership of capitals, etc.) to allocate resources efficiently. Thus there were fewer incentives for firms, workers, and farmers to become more productive or be concerned with the quality of what they produced (since they were mainly focused on production goals set by the government).

Before the reform:

 

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