Economics and the Factors of Production

Happy New Year.

I’ve been pondering, recently, what to believe about the economy. Sadly, there aren’t many reporters with enough grasp of economics to provide much of use, and most economists seem more interested in their pet positions to actually look at what’s really going on and what the real root causes are.

So, I’ve been rereading my economics books, checking out analytic pieces on both sides, and doing a lot of thinking. A lot of thinking. And here’s what I’ve come up with.

From “Economics Explained,” I recall that there are only a few things you can really do with money: you can spend it, you can save it, or you can invest it. (I had forgotten that saving and investing have a different effect on the GDP when you’re talking about consumer activity.)

If you spend it, your purchase contributes to the GDP: you bought a product or service, and in the process, used some of the factors of production—labor, capital, and land.

If you save it, your purchase does NOT contribute to the GDP: you chose not to buy a product or service, and in the process, you freed up labor and capital to be used elsewhere—especially by businesses, who will borrow your savings from your bank and use them to buy equipment, start a new business, etc. That’s a good thing if there’s a demand for labor and capital, because by making some available for businesses, you are helping to prevent inflation. (Otherwise, business demand has to compete with your demand by bidding up labor prices, interest rates, etc.) That’s a bad thing if there is little demand for labor and capital, such as occurs in a recession. All you’ve done is decrease consumer demand, which decreases GDP. In a recession, businesses don’t want to borrow your money.

If you invest your money, most of us are really just buying business ownership rights (or a claim on business debt) from someone else, unless you got in on an IPO. What effect that has on the economy depends on what the person who sold you the stock (or bond) does with your money.

So, it follows that government transfer payments don’t contribute to GDP, but government spending on stuff does contribute. Naturally, the recipients of transfer payments will probably spend them and contribute to GDP, but that money came from somewhere. That “somewhere” has less money to spend, so the economic question is which group would’ve made a better contribution. That’s key question #1 to ask.

The second key question is what happens when the government spends more than it takes in. Proponents of government spending to jump-start the economy argue there is unused labor, so putting it to work builds useful stuff (e.g. bridges) and puts money in the hands of folks who will spend it, thereby increasing demand for goods and thus helping GDP. In a recession, the capital necessary to put the labor to work is just sitting around unused, since businesses aren’t borrowing it. That makes sense as far as it goes, but I see a couple problems. First, the debt must be repaid, so the future interest payments will steal capital for decades, creating a drag on economic growth. Second, if the program creates an entitlement, then the need for funds will stretch to doomsday, and so will the economic drag. Third, if the capital is borrowed from other countries, they can’t put it to use in their own economies and employ their own labor. That seems like a problem, but I haven’t resolved it, yet. Finally, the implicit assumption of government spending as stimulus is that both labor and capital are unused. In the current financial crisis, a major problem seems to be that businesses can't get capital.

The third key question, in light of today’s never-ending government bailouts, is what that is doing to the economic need for creative destruction. The buggy whip industry had to die, and bailouts would’ve just delayed the inevitable. On the other hand, I recall an interview with Richard Branson in which he pointed out that the bank his airline uses nearly failed—and when he went to move his business’s money, he was advised to read the fine print; it wasn’t that kind of an account. He would have been in serious trouble through no fault of his own and despite the fact that his company was a solid going concern. That has me pondering…