Economics Babified: Chapter 2 - Wealth in a Free Market is a Positive Sum Game, Shared through Savings, Loans and Interests.
Economics 101 - Explained like we're 5, with sketches - The economy didn’t grow because people consumed more. People consumed more because the economy grew.
Hi friends,
Welcome to my second chapter of Economics Babified, where I go through the first principles of how an economy grows and why it crashes like we’re 5, with sketches.
These chapters are how I wish my high school economic classes were taught. In this chapter, I’ve taken on some feedback to include a new section called Data Storytelling. I hope this makes it a lot more relatable to you all.
Please keep the feedback coming! Thank you!
Previously
Once upon a time, there were three people - Amy, Benny, and Charlie - who lived alone on an island. The island was a rough place with no luxuries. In particular, food options were extremely limited. The menu consisted of just one item: chicken.
For our island residence, the economics boils down to day-to-day survival of waking up, hunting to catch one chicken per day with their bare hands, eating and sleeping.
However, Amy feels like there’s more to life than living this way. Thus she made a sacrifice to under consume chicken for one day and innovated on a more productive way to catch chickens.
Her risk has paid off, which produced a spear, where now she’s able to catch two chickens per day.
With her increased productivity, Amy has created a valuable piece of capital that allows her to catch chickens more efficiently. This means she can use every other day to do something else. The possibilities are endless.
Read the previous chapter here.
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.
Although the idea appeals to Amy more than giving away her spear, 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:
She can save what she has saved for future use. It’s the safest, but her savings wouldn't grow.
She can consume what she has saved.
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.
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.
She can try a combination of the above four options.
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 Has Leverage
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:
China’s average annual GDP growth during this period is 4.4% [Source: China government statistics and Economist Angus Maddison - The Organization for Economic Cooperation and Development, Chinese Economic Performance in the Long Run, 960-2030, by Angus Maddison, 2007]
China GDP per capita fell by an estimated 20.3% during the Great Leap Forward campaign by Chairman Mao Zedong to raise agricultural production for economic growth, following the Soviet-style economic policies [source: Great Leap Forward - Britannica]. China hoped to increase its production goals by increasing the working hours and the number of people working instead of investing in developing machines and other capital. This was also met with three consecutive years of natural disasters that devastated it’s farmers and led to nationwide starvation where an estimated 20 million people have died.
Chinese Per Capita GDP: 1950-1978($ billions, PPP basis)
Source: Angus Maddison, Historical, Statistics of the World Economy: 1-2008 AD.
To put this in perspective with another Asian country.
Comparison of Chinese and Japanese Per Capita GDP: 1950-1978($ billions, PPP basis)
Source: Angus Maddison, Historical, Statistics of the World Economy: 1-2008 AD
Shortly after the death of Chairman Mao in 1976, the Chinese government decided to move away from its Soviet-style, socialist economic policies. To do this, the government slowly introduced more capitalist, free-market principles, and opened up trade and investment with the West (US). They hope to significantly improve economic growth and living standards.
“Black cat, white cat, what does it matter what colour the cat is as long as it catches mice?”
- Chinese leader Deng Xiaoping, the architect of China’s economic reform.
China Introduces of Economic Reforms
The reformed started in 1979. Since then, here are some of the initiatives the Chinese government has done:
Most urban families ordered to limit family size to one child to stem population growth.
Allow price and ownership incentives for farmers of their crops.
Allowed farmers to sell a portion of their crops on the free market. This means the more motivated farmers can profit more than the others.
Four coastal cities were made into “special economic zones” to experiment with more flexible market policies to trade and take investment from the US.
Economic policymaking was shared with local governments rather than under the direction and guidance of state planning.
Citizens were encouraged to start their own businesses.
State price controls on a wide range of products were gradually eliminated.
China implemented the economic reforms in baby steps. This helped to identify which policies produced good economic outcomes (and which did not). The good strategies were rolled out in other parts of the country.
China’s Economic Growth Since the Reforms
China’s economy has grown a lot faster since the implementation of the reform.
From 1979 to 2018, China’s annual real GDP averaged 9.5%. This means on average, China has been doubling the size of its economy in every eight years (the power of compound interest!).
Comparison of China and United States Annual GDP Growth (%)
World Bank - https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG?end=2018&locations=CN-US&start=1961&view=chart
Poverty plummeted. In 1981, just three years after Deng’s reform project was launched, almost 90% of Chinese people lived in extreme poverty (defined by the World Bank). By 2013, that number had dropped to less than 2%.
China's extreme poverty rate, by World Bank definition
Our World in Data | Living on less than $1.90 a day in 2011
https://ourworldindata.org/extreme-poverty
People’s income skyrocketed. Not only is the typical Chinese person now not living in poverty, but many of them are doing quite well. Per capita GDP grew by nearly 24 times from 1978 to 2017.
China GDP Per Capita (2010 US Dollars)
World Bank -https://data.worldbank.org/indicator/NY.GDP.MKTP.CD?locations=CN