The Economy is Organic!

In this blog I intend to go over the basics of how an economy works, and how some of the interventions from the state affect it.  To begin with, I will write a brief analysis of all the market actors (Consumers, Laborers, Capitalists, and Entrepreneurs). It should be noted that a single person does not have to be limited to just one of these functions.

Consumers-  For example, all people are consumers.  Consumption merely means enjoying the product of the other three functions, Labor, Capital investment, and economic development.  Everyone starts out as a consumer, and it is for the consumer that all market activity is directed.  This may seem trivial, but there are schools of thought that teach what is called the Labor theory of Value, which indicates that a thing has value simply because work was put in to it (and not because consumers choose to purchase it).  It is the labor theory of value that have lead people like John Maynard Keynes to suggest paying people to dig holes as a policy for economic recovery.  It has also lead some to fail to understand how a person could have gotten rich selling pet rocks.  If the labor theory of value were accurate, there would be no such thing as a bankruptcy.  Consumers would not ask what the use value of an item is at the store, but they would ask things like "how hard did the person who made this work?" or "how long did it take to make?"  Clearly, this is absurd.  Nobody is buying the hole I dig just because I spend time and energy doing it.  

Labor- The function of labor is quite easily understood.  The Capitalist and Entrepreneur are the ones who have the resources to open up a production line, and they employ labor to get that production line going.  But labor doesn't always mean some sort of construction.  It can be much easier things; for example, football players and other athletes are considered laborers.  

Capitalists- This function is somewhat ignored within the general public when it comes to the economy today, but it certainly is not unimportant.  In order to apply resources in the production of consumer goods, one must come up with capital (that is, one always must be a consumer, and in order to spend time producing rather than consuming, it is necessary to save and forgo consumption).  For example, suppose you were stranded on an island in the middle of the ocean.  If you wish to consume as fast as humanly possible, you would try to catch a fish with your bare hands and hope you catch one quickly.  If you hold off your plans to consume, you can try to find a pointy stick first, or still farther, you could spend time making a net.  The reason for production is clear; you will catch fish faster and easier with the stick or the net.  In this example, the stick and the net are called capital goods (tools that increase the production ability of the laborer, you)

Entrepreneurs- This is the function of economic calculation.  The business owner who decides what is to be made, at what quantity, sold at such and such price, etc.  As stated in the "Consumers" section, all economic activity is directed at consumption.  What entrepreneurs do is try to figure out a product people would buy, and determine if it could be produced at a lower price than it could sell for.  If the entrepreneur is correct in his calculations, he will make profits (which means the capitalists will as well, and the laborers will continue to have work), if he is wrong, the business will go bankrupt.

It should be pretty clear that all these functions are interrelated.  The entrepreneur makes a forecast; the capitalist decides to give a loan to the entrepreneur for a percentage back in return; Laborers are then hired to carry out the production process; but it is ultimately the consumers who decide if the line of production is worthy of existence (not to mention how much money labor will make and exactly how profitable it will be for the capitalists and entrepreneurs)  and the entire thing can be looked at as the workings of time preference.   

Time preference refers to how long a person is willing to wait to consume.  If you are the type of person who says "I must spend all my money now because I like to, I need to", whatever the reason, your time preference is high.  And the more you are willing to wait and save rather than consume now, the lower your time preference is.  (This should also show that investment cannot go up while consumption remains the same in an economy.  This fact was one of they key elements that lead the Austrian economists in realizing housing was indeed in a bubble almost a decade before it hit mainstream.)  So, if investment leads to more capital goods, which makes it easier and more profitable to make consumer goods, the clear way to grow an economy is to adopt a lower time preference.

Time preference also determines interest rates and profits in equilibrium.  This is quite obvious when you think about it.  It is quite natural to want to consume all the money one makes... so if I am going to forgo consumption now in order to make interest/profits later, then the money I expect in return must be enough to rank higher on my demand schedule to be worth more than spending now.  Why would anyone go through the trouble of entrepreneurial risk and forgoing consumption, if only to break even?  It's simple, they wouldn't. 

The role money plays in all this is obvious.  Money flows where actors want it to, indicating their wishes.  If consumption is wanted, with a very high time preference, money will flow into consumption goods, and only to those goods consumers want.  If there are consumers with a lower time preference, projects will be invested in and the calculation process will be undertaken by an entrepreneur.  How much money exactly will determine the length of the process, the wages for laborers, etc.  Without money communicating time preference and demands, the entire process would be reduced a primitive situation where people trade goods directly (a fish net for a lighter or something, rather than determining how many fish nets should be made, and sold at what price, and then mass producing them)

So what happens when the state intervenes and say lowers interest rates?  A facade of investment and lower time preference is created.  And entrepreneurs go through the process of calculation and hiring labor to take on new projects, based on false signals.  True preferences will prevail in the end, when nobody is purchasing the final product these new projects were aimed at creating.  This went on in the housing sector for almost 2 decades.  It happens because consumers/labor/entrepreneurs/and capitalists do not communicate by talking to each other.  The capitalists do not find the consumers and ask them what they want, nor the entrepreneurs and any other group.  Money and interest rates are the means of communication.  When the government and the federal reserve interrupt that conversation, they throw off the entire thing. To clarify, suppose you are the parent of a ten year old boy.  You send him to the store one day to pick up some bread and milk, but the boy instead spends the money you gave him on a candy bar and a yoohoo.  You said bread and milk, but the boy told the clerk candy bar and yoohoo.  The market was saying "we want to consume now" (because these days Americans do not save and invest much, so we have a high time preference) and the banks took that message, and under the direction of the government and the central bank, said "uh ya, they're investing and want to hold off on consumption."

There are really only 3 ways this situation can work itself out. 1) Everyone could become aware of what has happened and change their preferences to match the bad message sent by the fed, so a lot of people don't lose their jobs and wealth.  This situation is absolutely unlikely to happen.  2)  The bad investments will be liquidated and the production process will go back to reflecting what people ACTUALLY prefer, which is a completely necessary step for any bubble, since the preferences are not real, but falsified by poor communication.  3) When the liquidation of the bad investments begins, the government and the fed will step in and keep throwing money at those same bad investments.  This is the most dangerous situation because since those investments are not ACTUALLY preferred, the amount of money that can be spent on keeping those production lines going is literally endless.  It is dangerous because when the government spends money, they spend tax-payer money... that is, they spend your money.  Bush and Obama, and any others, are not spending all this money out of their own pockets.  When the fed spends money, they do 1 of 2 things.  They either simply type a number into a computer screen, or order new money to be printed from the treasury dept.  Either way, the money they spend gets its value from all existing money, and lowers the value thereof (making prices raise.  essentially, a more sophisticated way of taxing).  If it is the fed creating new money to make up the losses, and they never stop doing it, the end result is the destruction of the currency through a hyper-inflation, which brings the value of all money to zero.  This is how a loaf of bread in the Weimar republic came to cost billions...

Again, this is a very simplex example of how an economy is organic, and a brief analysis of what happens when the government and its central bank interferes with just 1 aspect of that process.  The process gets infinitely complex when you consider that everyone is a consumer, but laborers can be capitalists and entrepreneurs as well, capitalists are usually entrepreneurs... 1 person may perform all 3 functions...  and then you must consider how many lines of production there must be, how long they take, etc.  Indeed, the complexity of the situation is the very reason no one person could ever run it all by himself...  This is obvious even before we consider that demand cannot be measured in any way.  Are you thirsty right now?  How badly do you want something to drink?  Shall I get out my tape measure to see how badly you want a glass of water?  These questions are pretty bizarre to ask.  Yet, when we assume the government can intervene and run the economy by performing mathematical functions (ironically, functions for which no constants exist, for you will not always want that glass of water), we do so under the pretense that politicians can possibly know these things for every single line of production in existence, as well as every single demand (which, demands are themselves endless).  In essence, we must assume politicians to be gods if we believe they have the knowledge necessary to pass laws and force everyone to do what politicians claim to know they want to do.  Bizarre indeed.