Sunday, June 22, 2008

Economics, As Understood By This Layman

  • the fact that we have an election coming up, and the two political parties are each trying to convince everyone that the other party has no clue about economics;
  • the fact that gasoline prices are double what they were a year ago; and
  • the fact that my doppelganger recently posted about economics (and he's not the only one),
...I've decided to jump into the fray, myself. And, as I like to do in when puzzling out a situation--and to avoid the charge that I'm being political, because I really do want to keep this blog from becoming a political blog--I figured I'd start by going back to first principles.

When considering economics and economic policy, there's a fact that we need to keep in mind, bind upon our hands and foreheads, shave onto our scalps or chests or wherever:

Economic growth is inherently, unavoidably painful.

This assertion, which I will attempt to elucidate below, explains a lot, actually: it explains why there's so little agreement between economists or politicians regarding the proper policy to pursue (as one is focused on growth, or future wealth; while another is focused on alleviating the short-term pain caused by this growth); it explains why there's so much economic snake-oil being peddled by economists, politicians, and assorted demagogues; and it explains why such a big chunk of the population is willing to buy said snake-oil.

Ok, here's my proof.


I'll start with a hypothetical example, and then broaden it to a general case.

Let's say we have a nation (call it Lower Slobovia) that's pre-industrial, and thus dirt-poor. And to keep everything simple, let's not consider the complications that international trade bring to the picture. Everything that gets consumed in Lower Slobovia, must first be produced in Lower Slobovia.

And further, let's say that the primary occupation in pre-industrual Lower Slobovia is subsistence agriculture. In fact, to feed the entire population, fully three quarters of the workforce have to be farmers. So the workforce breakdown might look something like this:
Of course, this is much simpler than any real economy would be. Bear with me; this is just a model, for illustrative purposes only.

The first thing to note is this: In order to keep everyone fed, people working in agriculture must produce a surplus of one third over and above what they consume themselves. That is, since farmers make up three-quarters of the workforce, each farmer must produce four-thirds of what he needs for himself and his family. It is this surplus that keeps the non-ag workers fed.

Or put another way, each non-ag family must consume the surplus production of three farming families to have enough to eat. Or to put it another way, the annual food bill of the typical non-ag family is three times the annual income of the typical farming family.

Any way you slice it, those farmers are going to be dirt poor.

Furthermore, notice how thin those non-ag slices are on the chart above. Given how many farmers are needed, there just aren't that many workers left over to produce the manufactured goods, or to build houses, or to provide health care. As a result, the product of these industries will be very scarce, and thus very expensive; your typical farming families aren't going to be able to afford much beyond what they can make or scrounge up themselves.

Clearly something must be done to improve this situation!

Ok, so let's say that someone comes along with some good ideas about intensive agriculture techniques. And let's say that these techniques allow a typical farming family to triple its agricultural output. Well, this means that once knowledge and implementation of these techniques become widespread enough, you won't need three-quarters of your workforce farming anymore--you can get by with only one-quarter in ag, and the rest can be redistributed to work in other industries. We can triple the number of workers in the other industries. The Lower Slobovian workforce will then look something like this:

Now this looks much better than before. Even if there are no productivity increases in the other industries--that is, a typical construction worker builds just as much each year after the Ag revolution as before--the fact is, now there are three times as many construction workers than there were earlier, meaning that three times as much construction can occur. And there is three times the manufacturing capability as before. And there is three times as much health care available as before. These things are much more available to the wider population, because much more of these things are being produced. The population represented by the second graph is likely, on the whole, to be a lot wealthier than the population represented by the first graph.


So... how exactly do we get from the situation in the first diagram to the situation in the second? What's the mechanism for redirecting all of that labor?

Ay, therein lies the rub....

Here's the way this transition happens under free market conditions:
  1. Farmers start learning about the new intensive farming techniques, and their yields go up.
  2. This causes a glut of food on the market,
  3. Which causes prices to crash. (Basic supply-and-demand there.)
  4. Collapsing prices cause those farmers who haven't adopted the new techniques--as well as some of those farming on marginal land, and who can't boost their own productivity--to go into deep poverty--worse than they were before.
  5. Eventually some of these less productive farms shut down, and the displaced workers go to the cities looking for work. (This ultimately reduces overcapacity in the agricultural sector, and is known as a "Recession".)
  6. All these new workers looking for work drive down the wages for unskilled labor. (Again, supply-and-demand: there's more labor than work available, so the price of labor drops.)
  7. But, meanwhile, the "haves" are doing well; the low food prices have helped their budgets, and they have extra cash to spend. So....
  8. Some entrepreneurs figure out that when you have low labor costs, and rich people with money to burn, that there is an opportunity there. New businesses start to spring up to absorb the demand, utilizing the excess labor. And existing businesses start to expand their operations.
  9. Things start to stabilize: as the excess labor gets hired up, wages start to rise again. As the food situation stabilizes, the rate at which farms go under drops and reaches a new equilibrium; food prices stabilize, and even rise a bit as the system finishes working its way through the glut.
  10. Eventually, a new equilibrium is reached. But it's not the same as the old equilibrium; as mentioned above, there's a whole lot more being produced by the other industries, meaning there's a whole lot more to go around.
Note that there's a whole lot of suffering contained in this sequence. Hopefully, by the time a generation has passed, the youth of Lower Slobovia know enough of their history that they are appreciative of the sacrifices their parents made to give them a more prosperous life.

Now, that's what happens when a free market economy has this kind of transition to go through. For the record, in Communism, the transition is a bit different, and is not infrequently marked by mass starvation.


This example needs to be generalized. Lower Slobovia is an extreme hypothetical example, but the mechanism of economic growth in the real world--and the sequence it follows--is very similar to the sequence I gave above. I give two real-world examples here.

The first one (which, alas, I have no links for): It is my understanding that in 1900, the U.S. had about forty percent of its workforce in agriculture. It is also my understanding that today, the U.S. has less than two percent of its workforce in agriculture.

We've been hemorrhaging Ag jobs! Soon we won't be able to feed ourselves!

Well, not really. Turns out that this two percent, today, not only produces enough food to feed the U.S., we feed much of the rest of the world as well. Since the turn of the twentieth century, our farms have adopted the use of mechanized tractors and harvesters (instead of labor-intensive animal teams), newer strains of higher-yield crops, improved irrigation, pesticides, fertilizers, refrigeration and mechanized transport. Put together, this allows us to grow much more food on an acre of land, with far fewer actual laborers, and with much less spoilage. We no longer need forty percent of our workforce in agriculture to feed us all; we can get by with less than two.

Of course, this transition has been really, really hard on all those old homesteading families that first settled the land. The family farms have been disappearing, and there have been some tough times for those families who stuck it out. And one can certainly argue that America has lost something valuable with the vanishing of the independent farming family; I'm certainly not disputing that case. All I'm arguing is that the Lower Slobovia sequence I mentioned above happens in America, too.

Now, this sequence doesn't just happen in the field of Agriculture--it happens in every segment of our economy, and it can happen to all economic segments at the same time--a situation we refer to as a recession. And during a particularly severe recession, jobs can go away that never come back.

Here's the other example: This is the Wikipedia page on trends in employment in the steel industry. Note in particular:
During the period 1974 to 1999, the steel industry had drastically reduced manpower all around the world. In USA, it was down from 521,000 to 153,000.
So our steel industry has been absolutely decimated, right?

Well, there's no question that it's less dominant than it was after, say, World War II. And it has to compete against low-cost imports, including highly-subsidized Chinese product.

However, even though the industry lost nearly three quarters of its workforce over the years in question, that doesn't mean our actual production went down by a similar amount. According to this report (see Table 2), our actual annual steel output at the end of the time period was pretty close to where it was at the beginning. There were some major ups and downs in the industry between those two dates, including the slaughter-fest of the early eighties that saw huge layoffs, but our industry adapted to the low-cost imports by becoming really, really efficient, and U.S. steel production is still the third-highest on earth. That's nothing to sneeze at.

What happened to all those workers who were laid off? Well, many of them are retired by now. Others eventually migrated to other industries. And the truth is, we've got whole new industries today that didn't even exist as recently as the early eighties. All those workers in the internet-related industries had to come from somewhere, you know.

That's the Sequence at work. We're wealthier now than we would have been; but there's no question that it was painful while it was happening.


Thus my statement: economic growth is inherently, unavoidably painful.

Now here's where it gets a little tricky. One can argue that the above sequence will, in the long term, bring a higher level of prosperity to the economy than existed before. But as economist John Maynard Keynes once put it, In the long term, we're all dead.

There are lots of unpleasant things in the Sequence. There are all those workers descending into deep poverty, and losing their livelihoods; there's the recession; there's the drop in wages; there's the expanding difference between wealth levels of the "haves" and "have-nots" (which this small-l libertarian isn't personally concerned about, so long as the absolute wealth levels for the less-wealthy keep increasing; but the wealth differences are a big deal to many people).

It is rightly the case that civilized people dislike seeing suffering in their fellow men--especially when those fellow men have done nothing wrong. It's one thing to reason out that in the long run, it will all work out for the better; but on the other hand, this line of reasoning doesn't answer the fact that this real, flesh-and-blood man standing in front of me has a family to feed and no way to do it. Our compassion demands that we do something about this.

Enter the "economic populists"--which, in this case, is the same thing as saying "socialists".

Their solutions generally involve direct governmental action to mitigate the worst of the suffering. Economic populists usually advocate things like:
  • Unemployment insurance, to make sure people have an income when they lose their jobs.
  • Minimum wage laws, to make sure that economic forces don't destroy the wages of the working poor.
  • Unionization, to give workers some leverage over the employers who set their wages and hours.
  • "Job Security", which usually means rules to prevent firings and layoffs.
  • Reduced work hours, to encourage companies to hire more. If you have a French-style 35-hour work week, it takes 8 workers to do the job that 7 workers could do on a 40-hour week.
  • Taxes on the wealthy, intended to reduce the gap between the haves and have-nots. Some of this is used for wealth-redistribution schemes, or to pay for the unemployment insurance.
  • Price supports for industries that are facing job losses. If the prices can be kept high, perhaps some of those jobs can be retained....
  • Tariffs against imports, that compete with industries facing job losses.
This is pretty standard stuff for economic populist parties and for socialists. I don't think you'll find a socialist party platform without these things on them.

But notice what effect these measures have on the Sequence:
  • The minimum wage laws tend to keep wages higher, which tends to undermine step 8: new businesses thrive on lower wages. Raise them too high, and new businesses have a hard time getting started. The presence of unions, additionally, tends to raise employment costs and discourage company expansion.
  • Rules on "Job Security" tend to block step 5, in which workers lose their jobs. This tends to hinder the flow of labor from unproductive companies to productive ones, or from over-producing industries to potentially-growing ones.
  • Reduced work hours artificially lower worker productivity, measured on an output per man-week basis. This tends to undermine the productivity gains at Step 1 that started this whole sequence.
  • The taxes on the wealthy tend to undermine step 7, which means the demand for new goods that drives the rest of the process never shows up.
  • Price supports and tariffs tend to stop the sequence at step 3. The prices can't drop, and this prevents anything else on the list from happening.
  • Unemployment insurance has an unfortunate way of reducing the demand for jobs (and thus the supply of labor), blocking the sequence at step 6. With unemployment insurance, workers can survive longer without jobs; this causes some unemployed workers to wait longer to start looking, or to not look as hard, or (in some cases) to give up and join the ranks of the discouraged workers.
In summary, just about every socialistic solution to the problems raised in The Sequence has a way of short-circuiting the Sequence. The process of redistribution of labor, which is an inherent and needed part of economic growth--gets blocked, or at any rate greatly delayed.

The trouble is, these solutions are quite popular, precisely because they are intended to alleviate suffering. Politicians win elections by running on platforms containing these solutions. It is probably to be expected then, that long-term, continuous, unimpeded economic growth is likely to be rare in human affairs; there are too many incentives for people in power to do precisely those things that derail the train.

It's late, so I'm going to stop here. More to come....


B. Durbin said...

Very well put, sir. I suggest you save this entry and use it later when explaining economics to your kids.

Timothy Power said...

Hello, Ms. Durbin!

You know, when I write one of these really long, intense, serious posts that take me until one-thirty in the morning to complete, I find that I rarely if ever get any comments on them, which makes me wonder whether people actually read them.

So you actually made it all the way to the end? And understood it? Really really? Someone actually read it and liked it! This made my day. :-)

Roger Z said...


I just found your site tonight while googling on something else, and wound up browsing around a little. I really, really like your site and might add a link to it at mine, maybe, with your permission.

Anyway, this post in particular is extremely well done! You seem to have a very intuitive way of understanding extremely challenging subjects. I've spent a lot- too much, actually- of time around economics, so I always like reading other people's take on it.

I also have a wife who hails from El Salvador (and is still living there at the moment, unfortunately), and my first trip there in April was a bit eye-opening. It threw something into perspective that I had never thought about before, and I'd like to offer up as a mild critique to your essay here. You've made one key assumption that until two months ago I made, and probably most everyone in the United States made: money. You assumed the farmers were not subsistence farmers.

The problem with subsistence is if there is a surplus of agricultural products, and prices collapse, it has little, if any, effect on rural life so long- and this is the catch- the utility you can gain from remaining on the farm exceeds... or is *perceived* to exceed... the utility you can gain from a non-agrarian lifestyle. In other words, if prices collapse, subsistence farmers can eat the surplus, or let it rot, it's no real skin off their backs.

I think a key missing from our understanding of economics is the role that scarcity plays in driving people out of subsistence cultures, should an alternative be available.

More than likely, the issue of scarcity is one that has been with us from time immemorial. As a species, it probably didn't concern us much until an alternative was present- that is, urbanization. I imagine one of the first benefits of urbanization was the ability to gather goods from multiple points (and one of the first causes was specialization?), so that if there was scarcity in one area, residents could draw more heavily from another area where that was less the case.

Probably another thing I'd point out is that I, like yourself, am a small "l"-libertarian (nice description, by the way!), but there is one thing that should concern us about inequality: it's the nature of how it arises. For example, right now in the United States there is a case to be made that inequality is increasing because the low-wage side of the labor market is essentially an open economy (due to illegal immigration) while the high end of the labor market is closed (due to extremely tight H1 requirements and job shortages), resulting in a wage bubble. I have no problem with people getting ahead based on their talents and, on occasion, good fortune (no pun intended), but we shouldn't disconcern ourselves with inequality so much that we miss when government failures may be the driving cause behind it.

A question for you- what do you think is the best way to alleviate short term suffering that allows the market to work most efficiently?

Timothy Power said...

Roger Z--

Thanks for dropping by and leaving your comment!

Your critique is duly taken. Good call; I should have caught that when I was writing the essay. My wife's extended family survived the Depression in just the way you described--by retrenching back onto the family farm, where they could feed themselves and survive without a need for much cash.

But I think the Sequence I mentioned is still intact in most circumstances. After all, those workers who have no land of their own, instead hiring out for wages, get hit hard by this sort of thing. And the specialization that's necessary in a modern economy plays a big role too; the more specialized your skills are, the harder it is to survive a downturn in your field.

Regarding immigration and its impact on economics: Fascinating subject, which for my own sanity I've decided not to touch on this blog. ;-)

As for your question about alleviating short-term suffering: Here's my short answer. The long answer would be an essay at least as long as the one you just read; the "short" answer will be plenty long itself. ;-)

I believe that our liberties exist only so long as people take care to use them wisely. If people use their liberties badly, they can turn society into a living hell; at that point the options are either anarchy, or for Leviathan to step in, revoke the liberties, and restore order.

The question that's most important to me--more so than typical questions of politics--is, how do we grow a generation of people who are worthy of their liberty? How do we build a solid civil society? I define civil society in terms of how We The People behave when Government is NOT looking over our shoulders. How do we bring up people who are capable of living in an orderly fashion, when presented with liberty?

I don't see this as an easy question to answer, but it's necessary to find an answer if we are to have both liberty AND order.

To answer your question: "what do you think is the best way to alleviate short term suffering that allows the market to work most efficiently?" I think the answer is to be found within civil society. That is, the individuals within a society must be willing, voluntarily, to chip in to help those around them. People must be willing to take upon themselves the relief of the down-and-out, instead of delegating that responsibility to the government.

And I think the people are quite capable of doing this sort of thing, if something moves them to do so. After all, look at how much money the American people--not counting the government--raised to help the families of those killed on 9/11; look at how much We the People raised for the relief of the Tsunami victims; look at how much was raised, especially by the churches, in the wake of Hurricane Katrina. And it's not just Americans, although I'm very proud of how generous we as a people are: look at the recent that the people of China exhibited to that horrible earthquake last month. People are often capable of doing great things spontaneously, without being ordered--often times, they respond better when they're not ordered.

And those are just one-time events. Look at all the hospitals and schools around that were founded by religious orders.

The idea is this: when we personally choose to help the down-and-out around us, the results are often more effective and longer-lasting than when a government tries to do the same thing. For one thing, a million citizens can see--and thus fix--problems that a mere hundred or so bureaucrats cannot. Furthermore, our gifts are just that: gifts, rather than entitlements; this can make a big difference on the part of the recipients.

But the flipside is this: if we don't take it upon ourselves to assist the down-and-out, eventually the government will step in and do it for us, often with coercive, socialistic solutions. After all, if enough of the down-and-out remain that way too long, they start voting as a bloc--and they will get a whole lot of sympathy from the broader society.

So that's my answer: in a nutshell, it's the responsibility of freedom-loving people, if they wish to retain their economic freedoms, to step in and take care of their fellow man as needed. This needs to be a voluntary response. But if that response is not forthcoming and/or not sufficient to the needs, eventually the government will find an electoral incentive to step in and start curtailing our economic freedoms.

Was that too incoherent an answer? ;-)