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What is an economy?

by William McGaughey

 

We tend to think of the economy in financial terms. Someone with money buys something which supports employment for someone else. Therefore, the way to revive the economy and increase employment is to spend more money. If consumer demand is inadequate, then government must come up with the needed dollars.

However, consider this: Money does not exist. It is a fictitious commodity. Money is a medium of exchange of little real importance except for the faith that people have in it. Its tokens are created when the seller of a valuable product accepts sea shells, cattle, gold, silver, engraved bronze disks, or elaborately printed slips of paper in exchange; and just as easily these monetary tokens can be stripped of value.

Therefore, do not feel flush in possessing stacks of dollar bills. Technically, they are just printed paper. Conversely, do not worry about debt. In a real sense, it does not exist. Just refuse to pay the debt. Default on it. However money and debt are distributed, the world will continue much as before.

So if the economy does not consist of money, what is it? The economy is the system that supplies human beings with the materials and other possessions that they need or want for living. Besides air which is free for the taking, we need food. We need clothing and many other things. We obtain them through economic activity.

Consider economic activity in a hunter/gatherer society. The men hunted wild game or fished for food. The women did the weaving and food preparation. No money was exchanged in this economy. Money as such did not exist. The same was true of primitive agricultural societies. Yet, people’s material needs were satisfied.

Money came into being when goods were traded or exchanged. Yet, even then, it is not always necessary for economic activity. In a barter economy, it’s possible to exchange goods without money: Just give something to one’s trading partner and take something else in return at an agreed upon rate of exchange. However, this system becomes cumbersome when goods proliferate. Then it is useful to have a universally acknowledged medium of exchange. Ideally, the monetary substance can easily be carried by merchants traveling from afar.

Gold and silver fit this description. Being durable and scarce, everyone recognized their value. Lydian kings in the 6th or 5th century B.C. stamped an image upon gold in a certain weight and thereby minted the first coins. Those gold tokens could be exchanged for a variety of goods.

Please recognize, however, that the essence of the exchange is not gold, it is not money, but the substitution of one type of good for another. One party to the exchange will have a surplus of one and a deficiency in another. He will trade the first to another person in order to acquire the second. His trading partner will have a surplus in the second type of good and a deficiency in the first. Therefore, each party will be brought into balance with respect to the entire set of materials that they need for living. The trade will be to their mutual advantage.

In short, the need for money arises when valuable items are exchanged. This cannot happen when people are economically self-sufficient. It cannot happen when the two parties (to a potential trade) each have enough of both products. Instead, products are exchanged when there is an imbalance in the possession of needed products. That comes about because the parties specialize in producing different things. They trade their surplus production for what is possessed by someone who specializes in producing something else.

Why do people specialize in certain kinds of economic production? It may be because someone owns land that supports a certain type of crop. It may be because someone has the knowledge and skill to do a certain kind of work efficiently and well. It may be because he has the tools supporting work to produce more efficiently. Therefore, it is more efficient to specialize in the type of production for which he is equipped by knowledge, skill, tools, and resources to be more productive than to try to do everything himself. The rest of his wants and necessities can be obtained through monetary exchange with parties relatively productive in those other areas.

In more complex economic systems, we have webs of relationship to produce and exchange products. There is a legal structure assigning ownership to various properties. Money, being a universally acknowledged medium of exchange, gives permission to purchase certain goods and services and to initiate economic enterprise. Property is valued in those terms. Ownership supported by money becomes an integral part of an economy based upon specialization of functions whose products are exchanged.

So in an advanced capitalistic economy, we have a division between owners and workers. Some persons own the means of production while others (workers) apply their time, skills, and personal exertion to tasks prescribed by the owners. The purpose of a business is to produce something and earn a profit. Therefore, the business manager, employed by the owner, coordinates activities under his control to produce efficiently and maximize profits.

However, the production must also be sold. That brings in the money that pays workers for their productive service and meets other expenses of the organization. Assuming that a business produces consumer goods, the origin of its revenue is the consumer market. The consumer market consists of people with money to spend for various purposes. Having the money, in turn, depends on what working people earn from their work or the owners earn from their profits.

And so, there is a circularity involved in this process: Workers earn money from paid employment and then spend it on products created by businesses employing other people. Consumer spending, in turn, supplies the revenue which businesses need for their operation. So long as these different activities remain in balance, the consumer economy will remain healthy. On the other hand, if an economy affords consumer spending without having been earned through useful work (welfare) or if work is inadequately rewarded (subsistence labor), then the process will break down. The economy will not be able to sustain itself in a robust condition.

One who grasped those relationships was the automobile manufacturer, Henry Ford. First, he mastered the phase of production in designing a superior product and building it cheaply on the assembly line. Mass production brought the per-unit cost of an automobile down to the point that the average person could afford to buy one. Second, Henry Ford made sure that his own employees were adequately rewarded. In 1914, he unilaterally introduced the $5-a-day minimum wage for an eight-hour day. In 1926, his factories switched from a six-day to a five-day work week. Ford did his part to provide both rising wages and more free time for working people.

When we think of reviving manufacturing, we usually envision that workers will become better trained in schools or that businesses will receive tax cuts or subsidies to introduce new equipment that will improve the production process. Henry Ford had another idea. In his estimation, the important thing was to strengthen the consumer market.

Wage increases were an obvious improvement. Equally important in Ford’s view was to provide adequate leisure for working people. He understood that unless people found a use for consumer products, they probably would not buy the product. Products are used more in a person’s free time than in the time spent at work. Therefore, the more free time, the more likely people will develop life styles requiring expanded consumption of various things and the more profitable businesses supplying those things will become.

When Henry Ford introduced the five-day, forty-hour week in 1926, he said: “The short week is bound to come, because without it the country will not be able to absorb its production and stay prosperous. The harder we crowd business for time the more efficient it becomes. The more well-paid leisure workmen get the greater become their wants. These wants soon become needs. Well-managed business pays high wages and sells at low prices ... But it is the influence on consumption which makes the short day and the short week so necessary. The people who consume the bulk of goods are the people who make them. That is a fact we must never forget - that is the secret of our prosperity.”

Trade unionists had long argued that shorter working hours were needed to offset labor displacement as machinery improved production efficiency. Technology permits more product to be produced in a given amount of time so that workers can be laid off without affecting the level of production. Alternatively, if we want the same number of workers to be employed, we can accomplish this by reducing the average hours worked in a given period of time. Employment and production can then remain in balance. We need the employment to maintain consumer purchasing power which, in turn, affects business demand.

When the Great Depression began with the stock market crash of October 1929, business and consumer confidence waned. Large numbers of workers were laid off. Henry Ford’s ideas were then influential. The Hoover administration and certain business leaders, as well as organized labor, thought of stabilizing employment by reducing the hours of work. In 1933, the U.S. Senate passed the Black-Connery bill which would have created a 30-hour workweek. However, some influential members of Congress and their staffs opposed this work-sharing bill as “sharing the misery”. The Roosevelt Administration introduced its own hours codes under the National Recovery Administration. In 1938, the Fair Labor Standards Act was enacted, establishing a standard workweek of forty hours.

Since the Great Depression was largely a cyclical phenomenon, one of the proposed cures for mass unemployment was counter-cyclical spending by government as advocated by economist John Maynard Keynes. The Social Security program was also established during this time as a means of taking older workers out of the work force so that younger people could find jobs. The effect of both was to use financial mechanisms increasingly to maintain employment. Government needed to fund public-works projects to create jobs for people who could not find them in the private sector. If tax revenues were inadequate to fund those projects, government should resort to borrowing. It could later repay the borrowed money when the economy improved.

Try as it might, however, the New Deal administration of Franklin D. Roosevelt was unable to bring the unemployment rate down to an acceptable level. Then the United States went to war against the Axis powers. As millions of workers were drafted into the armed forces, we suddenly had full employment. Production of war materiel was financed by war bonds. Although government was borrowing money to pay for the war, no one complained because the expenditure was seen as necessary. After the war, there was pent-up demand for consumer products. The U.S. economy roared back.

This lesson was not lost on certain economists. The public would accept borrowing for military purposes; and government borrowing would ensure continued spending that would keep the consumer market strong. That concept was embodied in a National Security Council memorandum, NSC-68, written by State Department analyst Paul Nitze with the help of Leon Keyslerling, chairman of the President’s Council of Economic Advisors. It argued that the United States could best sustain economic growth through an arms build-up to counter the Soviets. The military budget was increased from $13 billion a year to $50 billion. President Truman gave his approval to this approach when the North Koreans invaded the south.

Ironically, it was career military men such as George Marshall and Dwight D. Eisenhower who offered the most compelling arguments against using military expenditures to sustain economic growth. As a candidate for President in 1952, Dwight Eisenhower accused the Truman administration of trying to fool the American people with a “deceptive prosperity” brought on by inflation. Military spending, while sometimes necessary, did not create useful goods and services to accompany an increase in dollars. Eisenhower criticized the view that “any reduction in arms output might bring on another recession. Does this mean, then that the continued failure of our foreign policy is the only way to pay for the failure of our fiscal policy?"

Yet, this has continued to be the preferred approach. Despite President Eisenhower’s warning against “the acquisition of unwarranted influence ... by the military-industrial complex”, the United States government has built a huge military empire supported by contractors in various Congressional districts. The military has become a major employer as well as provider of funds for education. Social Security, begun during the Depression, has been expanded into a disability-maintenance program. Medicare has been added to help pay retirees’ medical expenses. The federal government did not repay its borrowed money during upswings of the economy but, instead, has sunk more deeply into debt.

Now we have an economy dominated by government. It does not just regulate. Government also takes money and purchasing power out of the economy through taxation while giving money back to selected contractors and other recipients. Government employment overtook employment in manufacturing around 1990 and now exceeds it by ten million workers. This represents a new kind of imbalance. While manufacturing workers furnish useful products, government employment provides often unwanted services. This kind of exchange, mandated by law, is essentially involuntary. The economy is out of kilter.

Here’s what has happened: The introduction of machines in agriculture, manufacturing, mining, construction, and other goods-producing industries has progressively improved output per worker-hour, also called “labor productivity”. A given employee is able to produce more output. There is not unlimited demand for food, housing, and other consumer goods so the market does not keep pace with the increased productivity. That means that fewer workers will be needed in the mechanizing industries. They are displaced to other sectors of the economy. Where do they go? To some other industry - say, iPADs - which offers new kinds of useful consumer products? Only a small portion of the displaced employees go there. Most go into areas of less useful activity. Some of the big ones are government, education, health care, and finance.

People sometimes wonder why they are experiencing greater economic stress when per-capita GDP continues to increase. That is because Gross Domestic Product, comprised of fungible dollars, does not distinguish between useful and wasteful products. For instance, it is not useful to me to have governments in the United States incarcerate 2.3 million persons when the “repressive” government in China has only 1.6 million prison inmates. It does not increase my standard of living for government to maintain 800 military bases around the world, or for doctors to prescribe a dozen or more pills to their elderly patients, or for my neighbor’s son to purchase an expensive college education so that, hopefully, he can find an entry-level job. At best, such products would be considered “necessary evils”. Without the presumed evil, no one would choose to trade anything to get them in return.

Since the Great Depression, the federal government has been charged with keeping the unemployment rate low - in the 4 percent to 7 percent range. Besides changing the definition a number of times, it has accomplished this difficult task through regulations that impose new requirements upon the productive economy. Take one example: licensing. Medical doctors, lawyers, and CPAs need to be licensed. Why not hair dressers, retail clerks, handymen, and baby sitters? We are in favor of higher quality, aren’t we? How about requiring baby sitters, to whom we entrust our children, to take a two-year course in that occupation and then pass a licensing exam? The possibility for increased employment by introducing extra requirements into any given enterprise are endless. So long as reasonably full employment is maintained, people will not complain. Therefore, government goes that route.

As I said, human labor is displaced from productive activities in agriculture, mining, manufacturing, and the like as production is mechanized. The immediate purpose is to reduce the cost of labor and increase profits. Profits go to the owners of such enterprises and, increasingly, to their top-level managers. Thus, the capitalist’s share of the economic pie increases while labor’s share grows smaller.

If, instead, government imposed regulations to reduce average working hours (as Henry Ford once prescribed), then some of the displaced jobs could be saved. The level of employee wages would also tend to be maintained as labor supply (defined in worker-hours of labor) shrinks. While working people would reap an undeserved bonus, we would at least avoid some of the wasteful activities that government imposes to keep unemployment low.

There is another threat to productive employment: outsourcing. Because labor and other costs of production are lower in China than in the United States, many U.S. firms have arranged to produce their goods in Chinese factories and then have them shipped back here to put put on the market. This is a sure-fire way to increase corporate profits and CEO pay. On the other hand, it breaks the link between the worker and consumer which Henry Ford and others said was “the secret of our prosperity”. Worker wages are not recycled back to U.S. businesses in consumer expenditures because the workers do not live in the United States. Instead, dollars are exchanged for renmimbi to pay the Chinese laborers who have taken their place in the economy. The Bank of China, facilitating this transaction, has accumulated an increasing quantity of U.S. dollars which may later be used to purchase debt or assets in the United States.

What is an economy? It ought not be a playground for politicians pretending to solve problems but a medium for balanced exchange. Our national interest also requires reasonably balanced trade - trade in goods and services rather than an exchange of goods for debt. So long as we Americans are hooked on the idea that only government money can create jobs, we will not have that balanced exchange. We may or may not renege on the debt bequeathed to later generations of Americans. Government needs to reduce its fiscal activities. In the meanwhile, we ought to scale back labor to what is needed for useful production and let people have more of the time left over in life after their material needs are met.

Having said that, however, I must acknowledge a criticism of the “Henry Ford” approach to economic recovery. The idea of stimulating more consumption by raising workers’ incomes and giving them more time to consume products strikes some as unhelpful at a time when over-consumption of materials is threatening the earth’s environment. To some, Henry Ford’s name is synonymous with an oversupply of automobiles. Do we really want more traffic jams? Could the earth handle an automobile culture in China as extensive as in the United States?

There can be little doubt that a day of reckoning will eventually come with respect to our consumption of physical materials. To some extent, greater leisure for working people would tend to alleviate the problem. Given extra personal time, they do not have to go out and buy new gadgets. Many will cultivate an interest in mental or spiritual projects. Instead of discarding used clothing, many will take time to mend what they already have.

The more spare time people have, the more likely they will search for more satisfying ways to spend that time. They will pay more attention to their children. They will seek to improve themselves in various ways. As it is, leisure-starved people with plenty of money to spend will try to build family relationships by giving gifts instead of taking the time to know the other person. The consumer mass market will not forever stay as it is. I think the next big thing is the cultivation of improved personal identity.

Henry Ford himself might not have promoted increased consumption of automobiles if he lived in our time of rising gasoline prices and global warming. He was smart enough to tailor his operation to existing conditions. Yet, I would defend his principle that consumer products, whatever they are, require adequate time to be usefully consumed. If there is a breakdown in the flow of production and consumption, increased leisure may be just the thing to fix it.

Work is the moral basis of supplying individuals with the materials they need for living. We need everyone working a moderate amount of time rather than have some become chained to super-human workweeks while others are entirely without work. It’s unfair to those who work to produce useful goods and services to have part of their earnings taxed away and be given to a class of welfare recipients. On the other hand, the welfare recipients are not to blame if they are able and willing to work yet the overtime hogs will not give up any of their opportunities for income. The root of the evil may be neither group but a controlling business/ political class that employs economists who oppose shorter work hours to justify their privilege.

Therefore, let all able-bodied persons in a society share in the responsibility of providing its material goods or whatever else (entertainment products, perhaps) that people freely choose to purchase. It should not be up to government to decide how people should be employed (as soldiers, educators, and jailers) or how they should spend their time. In my mind, there is no question that ordinary people will spend their time more usefully if they are free to decide that question than if government makes the decision for them. Government officials should be content with regulating the labor supply so that as many people as possible can participate in the process of working and earning income.

That leads to a final point which may be controversial. Free-market economics as conceived by Adam Smith must now be amended to take into consideration the earth’s limited resources as set against an expanding human population. It may well be government’s role to anticipate resource scarcity and take steps to moderate the impact. Government may, for instance, legitimately get into the business of developing renewable energy, preserving forests and sources of clean water, and, yes, facilitating the transition to an economy with lower per-capita consumption of our limited resources.

Meanwhile, government does also have a responsibility for maintaining reasonably full employment. In that context, its ability to regulate labor supply by encouraging employers to reduce working hours is an appropriate use of government power. It’s time for such steps to be taken internationally since unemployment is a problem in most industrialized societies.

 

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