Building an Economy Jude Wanniski February 11, 2000

Memo To: SSU students
From: Jude Wanniski
Re: Building an economy

[This lesson originally ran on September 18, 1998. It's as good as new, because it is so basic, but it has been altered slightly where it related to events of that period. If you are new to SSU and are worried about keeping up, this lesson will assure you that I go step by step, so none of you will have trouble completing the semester work. Those of you who have taken the trouble to register -- which you can do at any time -- will receive a related "reading" next week that will explain the importance of the Internet to mankind better than anything you have read thus far.]

* * * * *

Before there was a domestic or global economy there was only the jungle, every man for himself, he and his wife working like dogs to feed, clothe and house themselves and their family. An economy is the product of a community of people deciding to economize on their total work effort. By trial and error, they come to various agreements that cause the collective effort to produce more than individual efforts. By producing more with the same level of effort, they economize on labor. This may sound simplistic in a university course on economics, but it is surprising how many Ph.D. economists -- even Nobel Prize winners -- forget that the primary role of an economy is to produce more goods that satisfy human needs with less human effort. We often find them celebrating a statistical increase in the Gross National Product without noting that it may be the result of more people working harder for less after-tax income, with the tax revenues paying for things that are not satisfying human needs but are nevertheless counted as production. A superior economist studies a national economy or the smallest production unit with the question: "How can I get this unit to produce more with less effort? How can it economize?"

The history of civilization has been a history of masses of people finding new ways to organize themselves into more productive economies. In order to do this, people long ago discovered that there had to be a political component to the quest for economy. The "pol" in politics means "head," and a "polity" refers to all the people in a political unit. A poll tax is a tax on a person. A poll is the result of surveying opinions of individual "pols." Politics and economics are inextricably intertwined and have been since the dawn of civilization.

If a superior economist were to happen upon a previously unknown part of the planet, and find a million people living in a jungle, every man for himself, how would he go about organizing them into an economy? What kind of organization would make them more productive? In this lesson, we will take a small bite of that apple by discussing the concept of capital. Coincidentally, the world capital also derives from the word "head." The word "cap" sits on your head. A Mafia "capo" is a family head. The Capitol is at the head of the nation's capital. A capital is at the headquarters of a state. "Capitalism" is an economic form that centers on the individual. "Communism" is an economic form that centers on the community. "Socialism" is an economic form that centers on "society," which permits a mixture of individual initiative and reward within a larger context of community welfare. Socialism permits citizens to possess wealth in different degrees, but only if every citizen is guaranteed basic needs by the state.

The labels are not hard and fast, because all economies are mixtures of each. Before the end of the Cold War, the USSR permitted so little individual initiative that no citizen was allowed to own his own home, although on each communal farm, workers were allowed small "private plots" on which they could grow goods for private markets. Poland, on the other hand, permitted its citizens to own their own homes and farm their lands while the state owned almost all business and industry. When the transition to capitalism came, Poles had at least some "capital" which they could "capitalize," i.e, borrow against, in order to meet the challenges of the market economy. The Russians did not. In China, Deng Xiao Peng with the stroke of a pen, in the spring of 1978, turned all the state-owned communes into co-operatives to be owned and managed by the citizens who previously worked for the state. In this way, Capital was transferred to them.

Constructing an Economy

To construct an economy, let's think first at a high level of abstraction. Consider how a mass of people can organize themselves into an economy, as opposed to building one up from a family. If there are a million people, the problem for the economist is how to get them to contribute all they can to the national production pool. Of the mass, some will be able to contribute nothing, being too old, too young, or in school. Of those able to produce, some will be able to contribute only enough to earn part of their basic needs -- students or part-time workers. At the other end of the scale, there will be a small number who will be able to produce thousands of times more than they possibly can consume.

Think of Microsoft's Bill Gates or Standard Oil's John D. Rockefeller. The value these most productive of men added to the production pool had to do with insights they had on how to dramatically lower the cost of basic human needs. Gates's insight enables everyone on the planet to communicate more efficiently, especially the most productive people who can, with his contribution, themselves contribute several or hundreds of times more value in the limited time they have on earth. In the 19th century, Rockefeller saw the path that led to the efficient organization of the oil and gas industry. If not for him, someone or some others might have stumbled upon a similar path, but Rockefeller somehow got there first, perhaps saving mankind a year or five or even ten in its ability to use oil and gas more efficiently for productive purposes.

It is theoretically possible that under a communist system or a socialist system a person with Gates's or Rockefeller's insights would have come along. But it is much less likely that the economic system erected around them would have enabled them to develop those insights to fruition. In other words, the capitalist system, when it is functioning as it should, is more conducive to bringing to full potential the individual talents of otherwise ordinary men and women in the production of goods and services that satisfy human wants and needs. It does so by the combination of a market system that rewards the successful allocation of the economy's capital. In other words, if there are a million Communists, a million Socialists, and a million Capitalists, the market system that centers on developing individual productive talent will be able to locate more such talent among its million people and nurture it with financial capital than will the competing systems.

Financial capital? In all systems, those people who can produce more than their daily needs have to have some way of saving their surplus production. In a communist system, the government will permit individual competition in sports and certain forms of the arts and sciences, but only with the aim of serving the national collective. In the Soviet system, the state directed the masses of children to compete in the Olympic sporting events, with individual excellence surfacing through that process. Chess was given state sanction as a worthy realm for competition, as was ballet and the performance of the classics in music and opera. The process produced world champions. These individual efforts, though, were all totally reliant on state allocations of capital to sustain their organizations. Almost all the wealth of the nation was owned by the people collectively, controlled by the state. Individual citizens were permitted to own only small amounts of wealth as individuals.

The business of living is much more mundane than the glories associated with chess champions, the Bolshoi Opera, and stars in track and field. Most economic activity at the current state of technical, industrial and financial development requires a process by which small bits of capital are assembled from small bits of savings of ordinary people who are able to produce more than they need for their family's daily needs. This surplus will have its highest return on investment in people who have need for capital if the mechanism that connects the investor with the enterprise or the creditor with the debtor will itself be rewarded or punished for its success or failure in making the correct connection. The Soviet experiment ultimately failed because the mechanism of assembling small bits of capital by command and allocating them from a central planning point was incredibly inefficient. For the most part, the state had access to the same industrial technology available in capitalist countries, and if they didn't they could steal it. But the financial mechanism of matching surplus time, energy and talent with the highest and best uses of that capital was itself inefficient and wasteful. In the last 30 years of the USSR, it was typical for an industrial unit to request two identical machine tools of the central planners when only one was needed, because the industrial managers knew that if one broke down, it would take another planning cycle to acquire another one. Labor was being squandered to produce unproductive capital. One of the reasons Bill Gates has become the wealthiest man in the world is that Microsoft has participated in making "just-in-time" inventory possible, which means capital does not have to sit idle for long periods of time and consumer goods don't have to be discounted by becoming dated. All those little bits of capital that can be assembled from the masses of ordinary people baking bread or building homes or growing grain or cotton can be diverted to other uses than the maintenance of inventories -- perhaps the searching out via the market mechanism of another Bill Gates and a superior system of communication.

Trading Bread and Wine

An elementary picture I like to use to illustrate the basic economic condition is to think of a community where everyone on the west side is engaged in producing bread and everyone on the east side produces wine. They do what they do best, but those who produce bread need only half their production and would like to exchange it for those who have more wine than they need for themselves. In a primitive economy, they take their surplus to a central marketplace and haggle with each other until the exchanges are made. In a modern economy, a financial mechanism exists to buy up all the surplus bread and all the surplus wine with IOUs called money, and to sell these surpluses at a central point to the other side of town, taking back the IOUs. At the end of the day, the bread and wine producers have traded their goods with a fraction of the time spent traveling around and haggling. Instead of spending several days a month in the process of transacting, they spend only a few hours a month, and the saved time can be devoted to producing more bread and more wine.

The IOUs called money constantly are appearing and disappearing as the transactions are completed. The people involved in the financial mechanisms that arrange the trades keep some of the bread and wine for themselves. They buy it with IOUs they have earned by selling the bread and wine to the opposite ends of town at prices higher than the purchase price. In the USSR, this central mechanism of trade was manned by people who were paid the same whether they were poor, adequate or superior in matching bread with wine. Bread and wine would spoil in the process, and the amount the state would be able to pay for each would fall and the amount it would have to charge would rise. The amount of time saved in not having the travel about and haggle would decline, which would mean there would be less surplus time, energy and talent to devote to a higher level of production.

This is enough for you to chew on this week, although I will append an excerpt from a client essay I wrote in 1996 entitled "Economic Growth," in which I went over these ideas with different words. All I really want you to achieve in this lesson is an appreciation of what "economics" is supposed to be about -- "economizing." In future lessons we will add in the role of government and will push you to think about the two sides of town, east and west, as two sides of the planet, the "globalization" of the economy that really began early in the 19th century. Please address questions to me or raise them in the TalkShop. In that way, SSU students who have been with us for the first four semesters can help answer the easiest questions and probably many of the hardest.

* * * *

(The full text of the following excerpt from Economic Growth, March 1996, can be found on the SSU site under Essays.)

What we should admit to begin with, if we can, is that good socialism is better than bad capitalism. The logic of the statement is really inescapable. It is only when capitalism fails that people and nations resort to alternative forms of political economy. A socialist system that is working well is one that is fully deploying the nation's resources through a central plan that has the approval of the people. It would be superior to a capitalist system that is working so poorly that its adherents must find excuses for mass unemployment, widely diverging income classes, and deepening social pathologies. The price paid for any form of socialism is the loss of some degree of individual freedom, but when the only alternative is bad capitalism of the type described, a people willingly pay that price. In that sense, the capitalism that defeated Soviet socialism in the Cold War did not necessarily end the competition between systems. At least theoretically, we might imagine a new outbreak of stagflation here that causes an explosion of social pathologies and a sharp decline in living standards. At the same time, we can imagine a reconstituted Russian socialism, one that permits more market signals and more personal freedoms than the variety that collapsed. This could bring about a new competition having a different outcome. Good capitalism, though, is superior to socialism at its best. I think we know enough to make capitalism function the way it should, with an economy of labor, ever-increasing living standards for ordinary people, and increased personal freedom as well. The crisis in capitalism exists because the Ruling Class does not like or want the changes that we have proposed for the past 20 years, and has no alternative solution -- other than a managed economy. What is it that capitalism must do to perform to its ideal?

What must any system accomplish? At the core, it must provide a method by which its smallest constituent unit, a household, can save the surplus of its day's work for the day when it cannot work. This is because the highest priority of any unit of political economy is self-survival. The risks to survival are reduced by agreements among separate units to pool their resources. This enables those with a temporary surplus to share with those in temporary deficit. The family unit itself is such a system, which enables the young to draw upon the productive resources of their parents, returning the resources when their parents are too old to be productive. Civilization began with speech that enabled neighboring families and neighboring clans to contract with each other through verbal IOUs. "Money," as a palpable medium of exchange, soon followed as an extended form of commercial speech.

It is only in the last four centuries, though, that money began to overtake verbal transactions or the bartering of goods as the primary means of exchange. In earlier epochs, through the Middle Ages, only a minority of people ever saw money. And then, it was employed almost exclusively as a means of exchanging one set of goods for another -- not for developing longer term contracts between people who normally would not come into physical contact with one another. In these earlier epochs, such "bond transactions" were generally limited to government finance of war or public works or church finance of cathedrals. Capitalism is a system by which ordinary people can exchange their daily surplus time, energy or talent (their capital) for claims on the future production of others. Its viability rests on its internal mechanisms for assessing the risks attendant to such exchanges of goods for promises. Even in the most primitive forms of political economy at the dawn of civilization, a family that pooled its resources with its neighbors had to be adept at assessing the reliability of its neighbors in holding up their end.

Modern capitalism has evolved to a level of sophistication that permits the largest and most liquid pools of capital. It is held together by a vast and elaborate mechanism for assessing risks and creditworthiness -- a mechanism that is known as the free market. The modern mechanism is so close to perfection that it is a waste of time for any of us to devote resources to getting it closer to perfection. That is, the broad U.S. marketplace itself is 99% as good as it can possibly get, in terms of pricing goods and assets and assessing risks and return on investment. Information on every industry and enterprise is readily available and already flows at lightning speed. The financial service industry will continue to evolve in one direction or another, but it will have to do that just to stay at 99% efficiency. Its limits are not in its structure, but in the quality of analysts available to correctly assess and price information. At the other extreme, Reuven Brenner points out, are the new financial markets in China, which must traffic in information about industry and enterprise that is always suspect -- there being no tradition of open communication of bad news and good. It is, after all, the political marketplace that is still far short of its optimum levels of efficiency, in China at a maximum, or in the United States, at a minimum. As just one example, the entire U.S. economy could only perform better if the regular meetings of the Federal Reserve Board were open to the public.

Capitalism, we must always remind ourselves, is not a political system, but an economic one. The distinction is extremely important, for it frees supporters of capitalism from having to defend it as a caring or compassionate institution, which it is not. It is coldly mechanical. Capitalism in and of itself functions according to the law of the jungle, as amended by the laws of man. At the margin, capitalists will do anything the law allows in seeking profit. If 999,999 capitalists leave something on the table, at its legal and moral edge, there will be one to take it up, especially if it means survival. And why not? A letter to The New York Times on this subject caught my eye on March 14, "What Capitalism Means," by Eli Zaretsky, a visiting professor at New York's New School: "Capitalism by itself produces only greed and exploitation. The great successes of the modern epoch are due to social movements like populism, progressivism, new deal liberalism, socialism, feminism, movements for racial equality and even communism, that have insisted that profit be tempered with social concerns." This sounds harsh, but it is not an unreasonable position. By itself, capitalism could be as savage and Darwinian as Marx supposed it would become.

In this country, however, capitalism is not by itself, but is twinned with the kind of active democracy that even Marx allowed could save it from extinction. Democracy does so by tempering profit with social concerns, although Prof. Zaretsky would have to agree that profit can be tempered to death, and that profit occurs only by putting capital at risk. Marx himself understood that it would be silly for a capitalist to buy "C" commodities for an "M" amount of money, as he put it in Capital, with the object of then selling them for the same "M" amount. The capitalist buys "C" commodities -- including labor as a commodity -- hoping to sell the new product for "M + 20%," Marx suggested. If he has guessed wrong or the market has shifted, the capitalist may be forced to sell at "M - 50%." There is no doubt that Marx, as a classical economist, understood that the capitalist must be rewarded for putting capital at risk. Unless there is risk-taking, there can be no growth. "M" will remain "M."

Now carry the impressions forward to the modern mechanisms of the market-- the banks, credit unions, insurance companies, stock and bond markets, and all other market elements that can extend or withhold capital. They absorb the total mass of capital, assess myriad demands upon it and dispense it in little bits and pieces according to a schedule of likely returns on investment. In aggregate, the mechanisms are necessarily cold and mechanical, though within the mechanism there are kindly and generous country bankers making bets on unlikely credit applicants. The mechanism of the market, of course, sorts out those kindly and generous country bankers who make bad bets, for the highest priority of an institution is self-survival. In the same way, the mechanism of the market will reward those icy, gimlet-eyed investment bankers who bet on only sure things that turn out to be sure things. In between, there is a Bell Curve of some incompetents and many competents who comprise the market mechanisms, reckoning with varying degrees of precision the return-on-investment (ROI) for the organic mass of a nation's capital.

This mechanism will calculate ROI just as precisely when the central government imposes confiscatory taxes on capital at risk as it does when it absolves it of any tax. The market does not care. It is cold and mechanical, in the end as automatic as the tote board at a race track. It grinds out its dispensation of the bits and pieces of capital it absorbs as long as it calculates positive odds for ROI. When the odds turn negative, it stops accepting capital that it cannot dispense. Even kind and gentle country bankers will hesitate and retreat when they confront an obvious bad credit. We frequently encounter kind and gentle investors who tell us they do not care that their investment income is heavily taxed. They will invest anyway. We are sure they are telling us the honest truth, but they are not on the margin. The cold and mechanical market is absorbing their gifts of capital along with all others who casually contribute capital. The greater returns go to those who are not so casual, just as serious horseplayers over time will outperform the casual bettor. The nation as a whole benefits by having its capital -- the surplus time, energy and talent of all its members -- wisely invested.

It is when a nation's political system fails its economic system -- when the market mechanism must refuse to finance unemployed resources because of a persistent negative ROI -- that the masses have little choice but to turn to socialism. The body politic will permit the capitalist ruling class some reasonable margin for error, but it cannot permit either mass unemployment or a persistent decline in living standards that threaten the basic family unit. As they did in the 1930s, ordinary people will use the democratic political system to force socialist policies into play when capitalism fails. The social safety net we now have is the refined product of the American electorate of the 1930s. Without having the benefit of a democratic political system, the people of Russia in 1917 produced a much less refined safety net.

Capitalism did not fail in the Great Depression because profit was burdened with social concerns. It failed because the capitalist ruling class saw an opportunity to increase its profits by an increase in the protective tariff -- using its political muscle to push Smoot-Hawley through the Republican Congress and persuade President Hoover to sign the legislation. This was a blatant intervention in the market, not for the usual purpose of increasing government revenues, but to engineer a social outcome desired by Big Business. Instead of producing the desired effect, the big tote board on Wall Street crashed as ROI suddenly went negative on a host of capital investment dependent upon international trade. Capitalists had only themselves to blame for the New Deal that followed, with its myriad market interventions on behalf of the working class -- the labor legislation, minimum-wage mandates, farm programs, social security and public power programs that offended the sensibilities of laissez-faire advocates. Once the capitalist Ruling Class uses the tax system to redistribute income instead of raising revenues, how can it complain when populists appear with demands that the tax system be used simply to soak the rich? Because they had no better choice, the masses accepted the diminution of personal freedoms that government market intervention inevitably entails.

Survival requires risk-taking. If the capitalist market mechanism will not accept the risks of financing enterprise that will enable ordinary people to exchange with each other the fruits of their labor, it makes perfect sense to have government take on those risks. Conceptually, an elite socialist team at the center replaces the capitalist financial services industry. The private market mechanism essentially buys up all the nation's productive output and then sells it according to market pricing signals -- taking a cut to cover its work and its risk. The public mechanism also buys up all the nation's production, but redistributes it according to a plan. The difference is that a socialist system must ignore most of the signals that bear on ROI, taking all the risks inherent in putting everyone to work and absorbing losses that result from errors in the plan. Socialist systems that retain broad elements of market price signals can mitigate such errors, as Sweden has for many years. The experiments in total planning broke down in the USSR and Communist China as planning errors -- usually the result of clogged communication channels -- came to dominate the economies. This meant less and less freedom for the work force. In the end, interlocking state monopolies came to operate at a fraction of planned capacity because of persistent interruptions in the supplies of one critical part or another. Mass unemployment had been eliminated, but production of goods and services was imploding.

Since 1978, China has been gradually restoring market mechanisms capable of better allocating the nation's enormous pool of unutilized capital. Its ruling class remains understandably wary of headlong experiments in laissez-faire capitalism or popular democracy, instead moving incrementally on both political and economic fronts. The former Soviet Union, persuaded by the West to throw itself headlong into capitalism via "shock therapy," has quickly produced the rudimentary market mechanisms for assessing ROI. The confiscatory tax and unpredictable monetary systems adopted by Moscow, though, guarantee that almost all private initiatives face a negative after-tax return on invested capital. The nation's social fabric continues to disintegrate as only an underground Mafia of privileged entrepreneurs amasses great wealth, paying modest bribes instead of murderous taxes. It is in the interest of this privileged class to maintain this corrupt status quo, which is why the masses once again are tempted to turn to the state and the Communist Party for relief. Unhappily, the western economists who advise the democratic government of Boris Yeltsin have little appreciation for the role the market plays in assessing macroeconomic tax and monetary risks to capital investment.