Building an Economy Jude Wanniski September 18, 1998

Supply-Side University Lesson #2

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

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 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 all its citizens to own their own homes while the state owned almost all business and industry.

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. Grates'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.

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 lOUs called money, and to sell these surpluses at a central point to the other side of town, taking back the lOUs. 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 lOUs 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 lOUs 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 link to 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.

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