Over the past century or so, academics have made great progress in many areas, including:
Albert Einstein's progress on the theory of relativity
Alexander Fleming and his discovery of penicillin
Francis Crick and James Watson discoveries about DNA, etc
However ...
There's one field of research where we haven't made much progress, and that's within the field of economics
For the investor, a growing economy is an important assumption for his long-term returns. And that is why this is ...
A top-five takeaway summary of the book "How an Economy Grows and Why it Crashes", written by Peter Schiff
And this is The Swedish Investor, bringing you the best tips and tools for reaching financial freedom through stock market investing
Takeaway number 1: The primary goal: increasing productivity
First, we'll go through three concepts that are very important for an economy to grow and
then we'll handle two factors that are important for an economy too, but that, when mishandled, can cause it to crash
A good definition of an economy is this:
"The effort to maximize the availability of limited resources to meet as many human demands as possible"
We demand quiet a lot ...
Basic demands include things such as food and shelter,
but we also demand more advanced things these days - such as smart phones that come with the latest technologies and
super-cars that come with great acceleration and environmental bragging rights
Say that ... it previously took people an average of
0.2 working days to meet their daily demand of food
1000 days to meet their demand of getting a shelter, 10 days to get that neat smartphone and
600 days for the super-car
But today it only takes 0.1 days,
500 days, 5 days and
300 days to meet those demands
The economy has then been growing
An increase in productivity has allowed food, shelter,
smartphones and super-cars, that of course are limited in their quantity, to become more readily available to the general population
This is the goal of an economy. Think about it!
Compared to before, you can now get a house, a super-car, 10 smart phones for all your relatives and
food for 1000 days and still have 50 days left for leisure time compared to buying just 1 house before!
This must be a good thing. Just think about how many days you can spend reading books in a nice hammock!
Super-cars don't produce themselves at the price of 300 working days instead of 600 days just by coincidence
There are a few prerequisites for this. It usually takes new tools, which come from
innovation, which in turn comes from savings and risk-taking
No person is particularly innovative if he has to work all day
just to fulfill the basic need of putting food on the table for his family!
For an economy to increase its productivity then, which is the primary goal,
savings are required, and this is what we'll cover in the next takeaway
Takeaway number 2: Savings benefits everyone
Why savings are important for an economy to grow is quite easy to illustrate
Peter Schiff provides an excellent illustration in How an Economy Grows and Why it Crashes, about three fishermen living on a deserted island
But for that you'll have to get the book yourself
However, just think about it like this:
For every large or semi large project - there must be savings
If no one in the economy saved up more than a single day's worth of money, how would then, for instance ..
... large infrastructure projects be built?
... new medicine be discovered?
... industrial innovations be made?
Such projects cost up to many thousand days of savings from many thousand individuals to complete
Now, all savings are not created equal
Some help the economy grow faster than others
There are 4 primary ways which savings can be used. They could be:
- Saved for a rainy day
- Consumed for extra pleasure
- Lent out to someone in need; or
- Invested
The first alternative doesn't really help the economy grow directly, but it is a great buffer for times of turmoil
Some individuals, companies and governments have learned this the hard way during the current pandemic
Their second alternative doesn't help the economy grow. This is the worst use of savings
"The economy doesn't grow because we consume more, we consume more because the economy grows"
According to Peter Schiff,
thinking that we can spend ourselves out of economic troubles is the main problem with the current paradigm within the field of economics
Consuming more than we can afford today will eventually be troublesome, either for our future selves, or,
for our children
Loans are the third alternative, and if they are made for business purposes rather than for consumption,
they can really help an economy grow
Just think about the aspiring entrepreneur. Without savings from either himself or someone else,
he or she can't possibly build his own business
because he'll need a steady stream of income to put food on the table for his family
The fourth alternative, which is investments, is great for the same reason that business loans are great
By looking at these 4 alternatives, it's easy to see that a capitalistic economy works
The lender wants interest payments and the investor wants dividends, and these are both
selfish motives, but they will have positive spillover effects to everyone else in the economy too
If the person who has savings wants to earn more on those savings, he'll have to invest or lend them out to others
A very important concept here is opportunity costs
Just like pretty much everything else,
savings are limited
Savings that are used for consumption could have be used for business loans or investments
It is therefore harmful for the growth of our economies that most governments are running monetary policies
which incentivize consumption but disincentivize lending and investments
I'm getting ahead of myself here, but we'll get to this later!
Takeaway number 3: Comparative advantages
Once upon a time, there existed an economy where only food, shelter smartphones and super-cars really mattered
(in other words not too different from the one that we have today)
In this economy, only four people lived:
Able, Babel, Cable and Durable
They were all equally interested in food, shelter, smartphones and super-cars
What they weren't though, was equally efficient in producing these items
Babel, Cable and Durable could produce one day's worth of food
by working 0.2 days, while Able could produce it in just 0.1 days
Babel was the most efficient shelter producer. He could build one in only 500 days, while it took the others 1000
Cable was a gifted smartphone designer and it took him just 5 days to produce one while it took the others 10 days
Similarly, Durable was the most skilled super-car maker at a production time over 300 days,
instead of 600 days like the others
If they use their talents in an optimal way, they should let Abel produce the food,
Bable build the shelters,
Cable assemble the smartphones, and Durable make the super-cars
Over a lifetime, they each demand food for about 30,000 days,
5 houses,
500 smartphones (yes, these guys are quite clumsy) and 10 super-cars
Now, if they don't use their skills, or
"comparative advantages" in an optimal way, and produce everything themselves, they would each have about
10-11,000 days of leisure over a lifetime
However, if they use their comparative advantages and let each do what he is best at and then trade goods with each other,
they'll have between 18-20,000 days
Simply put - if workers in an economy specialized at what they are best at, the
productivity of the economy will grow
Comparative advantages are important for the economy within the country, but it is also important for the total economy across the globe
For instance,
if King and Ling, who come from an outside country of Able, Bable, Cable and Durable would be capable of producing food in just
0.05 working days and shelters in just 250,
everyone could have even more leisure time
Moreover,
more savings would be available for business loans and investments
which could increase the productivity of the economy even further down the line
You might ask: But what would then happen to Able and Bable?
Well, with some savings or potentially a business loan from Cable and Durable,
they would probably discover that everyone is also interested in buying some fancy clothes and fancy watches,
now that there's so much leisure time
Remember this: the goal of an economy is not to provide jobs. The goal is to maximize productivity
In an economy where productivity is increasing and comparative advantages are maximized, the prices should actually be decreasing
Ling can sell shelters at the price of
350 working days and still make a profit, while Bable had to sell them at the price of
600 working days to make the same profit
Takeaway number 4: The role of the government
There are a few services that arguably should be provided to everyone in an economy, and that, for one reason or another are
poorly provided by a free market
Almost everyone agrees that two such needs are those of personal safety and justice
For example. Abel, Bable, Cable and Durable
might consider giving away some of their production to hire Enable for security,
and Fable for justice
Enable and Fable would then be hired as this country's governmental employees
One important thing to notice here is this: The government itself doesn't produce the basic needs of the economy,
it uses the taxpayer savings to provide services
For this reason,
government spending is the same as taxpayers spending. Never forget this.
A bit more questionable is when the government starts to provide services like health care,
infrastructure, education and
banking (we'll get to bank in the final takeaway) Sure, these are all services that are demanded in a modern economy,
there's no discussion about that. The question is just if the government can provide them in a more efficient way than the marketplace can
Consider this:
Politicians want to be reelected
For this reason, governments spend savings where it is politically most critical to do so
Private lenders, on the other hand, only spend savings where it is economically defensible to do so
Because of this, private lending is more efficient in bringing out the strongest species and speed up the evolution in society
Once again, the key concept is opportunity costs
Savings are necessary for the economy to grow, as we've seen previously, but they come in limited quantity
And remember that the government is nothing more than a facilitator of private savings
If the savings are wasted, the economy grows much slower than it could have
In some cases, it even causes it to crash
During the financial crisis for instance, it could be argued that the government played an important part in the downfall
The boom that occurred in housing prices was partly caused by governmental actions
The federal interest rates had been lowered to make borrowing cheaper and
banks were incentivized to issue riskier mortgages as they knew that they could sell these loans
immediately to two governmental entities called Fannie Mae and Freddie Mac
In other words - the government decided that
American private savings should go towards an upgrade in the housing standards of its people, especially people with limited finances
Let's just say that this turned out to be a very poor use of savings
If you want to hear more about the whats and whys of the financial crisis,
check out my summary of "A History of the United States in Five Crashes"
Takeaway number 5: The function of banks
Banks facilitates two great functions in society:
- They allow people to save in a safe way; and
- They may take more educated decisions when it comes to how the savings should be allocated than the average individual
In this way, banks increase the productivity of savings
The interest rates or payments to those who decide to lend their money to banks are decided by three factors primarily:
- A desire to maximize returns on deposits
- A fear of losing capital on risky projects
- A time preference for consumption
Here's an interesting thing in the economy today
If the government would decide that the price of a car is a fixed
$20,000, or that a smart phone must cost $500, what would you say about it?
You would probably yell:
Communism!!
We do not enjoy when the government intervenes with the price and production of goods as,
after all, we've seen what it has done to economies in the past
However, for some reason we are okay with the government setting the price of savings and loans
In the US, the Fed is effectively determining the price of money by deciding the interest rates at which
all other banks can borrow and lend at through the Federal Funds Rate
Here are three reasons of why it would be a better idea to have individual banks decide on this rate themselves,
much like in any other part of a modern economy, rather than having a centralized entity deciding on it
The federal representatives do not have the same "skin in the game" as the owner of a bank has
For this reason, they make short-term decisions that the business owner of an individual bank would never do
It is very questionable if the centralized Fed can make more informed decisions
than the aggregate of millions of independent decisions (well, at least more or less independent) in the marketplace
The Fed typically makes decisions that are based on political, rather than economical factors
The chairman of the Fed, for example, is nominated by the President of the US
So the fate of the President and the Fed chair are intertwined, and I bet that you understand yourself what type of consequences this might have
The inflationary monetary policies that are followed today are harmful to our economies
They are harmful because they incentivize spending instead of saving
This is important:
"Inflation is simply a means to transfer wealth from anyone who has savings in a particular currency
to anyone who has debt in the same currency"
As we saw in takeaway number 2,
savings are necessary for an economy to grow
Moreover ...
Credit and leverage being used in a stupid way
has been one of the primary reasons of all of five of the greatest economical crashes in history
If you'd like to hear more about these crashes, and possibly become a
little bit more aware of what might cause them in the future, head over to my summary of the book
" A History of the United States in Five Crashes"
Cheers guys!