Saturday, April 11, 2009

A new concept of economic growth.

I think the dominant theories of economic growth all evaluate symptoms of growth(increased wealth, more jobs, less debt, more products) rather than the substance of economic growth -- which, I will argue, is productivity.

To understand the heart of economic growth, envision 5 people stranded on an island. If they want to improve their standard of living -- the availability of food, the degree of leisure, their capacity to travel, increased health care etc -- what do they need to do?

First, I'll tell you what they don't need. They don't need "jobs." I could give them all "jobs" digging in the sand and filling the holes back in -- we'd all starve. It's not about money. A ship could run aground carrying billions of dollars of gold. They'd still starve. It's not about equality. They could all divide up the resources equally. They'd still starve.

The answer is, of course, that they need to produce useful things. They must produce food, clothing, housing, healthcare, etc.

The key to economic growth (i.e. an improvement in the quality of their lives) is in increase their productivity. For instance, instead of hunting fish with a spear, you build a net, set it in the water, and let it do the work for you. Instead of spending an hour a day bringing water from the stream a mile away, you build an aqueduct. Now, instead of spearing fish and trudging with buckets all day, you can do something else -- sew clothing, hunt for boar, write a play. More is being produced with the same resources. Economic growth.

Now let's apply that viewpoint to western economies. The development of the automobile greatly increased productivity -- all the energy that had been wasted on travel time, care for horses, spoilage of products before reaching market, etc -- was reduced. People could produce more with less. Result: enormous economic boom in the 20s.

But what happens when people don't understand why the growth is occurring, and therefore expect it to continue indefinitely? What if they don't understand that things are getting better because cars are entering the marketplace, but as soon as everybody has a car, things will stop growing?

Well the same thing that would happen if the people on the island saw that food production increased with each new net, thought that food production would continue to increase indefinitely, and started acting recklessly -- let's say, building a string of fish restaurants big enough to feed 50 people a day. On an island with only 5 people. Sure, food production increases for a while. But eventually it levels out, because 5 people can only eat so much fish. And anybody you hired to man the extra fish stands ends up out of a job.

Back to the real world. People see the stock market soaring because of increased productivity, so they put their money into stocks. But eventually the profits stop increasing. Then the people that were in stocks just for the rising value get out. Stock market crash.

In the 1920s, Ford revolutionized America with the car. Everybody's lives changed. But eventually, everyone has a car. Then things reach an equilibrium. Profits stop rising. Companies across the economy have improved the efficiency of their operations as much as they can. And things flatten out. And when things flatten out, people get out of the stock market. 1929.

I'd argue the same thing drove the economic develop of the 80s, 90s, and early 2000s. In the 80s, home computers raised productivity in the home and office enormously. By 1992, pretty much everyone has a home computer. Recession. In the mid to late 90s, the internet sliced the costs of communication and information transfer. Companies sold directly on the internet. Hundreds of man-years saved every day, and freed up to do other useful things. Then everybody has the internet. Dot-com bust. Then in 2003, housing prices boom because the government is requiring banks to give loans to less than credit-worthy individuals -- everbody's home values go up. People see home values going up and don't know why, so they buy. Suddenly, the people that couldn't afford the houses stop paying. Foreclosure. Housing prices drop. 2007-2008.

The problem lies, I think, in a failure to understand what's actually causing the change in the economy. It wasn't voodoo that made housing prices go up -- it was increased demand. Figure out what's driving increased demand. Oh yeah, people buying that couldn't get loans before. Maybe that will be a problem.

Same thing with the dot-com boom. Dot coms weren't magic companies that would grow unceasingly. Eventually, the internet would be used by everyone, for just about everything it could be used for. And when that happens, the profit margins on those companies are going to plummet.

Same thing with PCs in the 80s, and every other revolutionary invention that has changed our lives. Things get better very quickly -- but for a very specific reason. And when that reason's gone, things are going to stop improving.

The lessons here are two-fold.

First, economics is not about numbers -- it's about productivity. No different than a group of five people who had spend all their time spearing fish before now able to build a hut and sew clothing, because they invented nets to catch fish for them. Increase productivity, expand your economy. That's what our economic policy needs to do -- focus on improving our productivity -- the degree to which we are able to produce socially useful things!

The second lesson is that you can probably predict market rises and falls by figuring out what -- in the REAL WORLD -- is driving an expansion. Because when that force stops improving things, you're going to have a recession. And because nobody else sees it coming, you can make a killing on the markets by getting out before they figure out what's happening.

No comments: