Monthly Archives: July 2011

Money doesn’t matter

Can one make too much money? Are the poor getting poorer? Will the rich amass so much wealth that it will leave none for the rest of us? No. Unfortunately affirmative responses are all too common and simply betray an ignorance of basic economics.

The mantra “the poor are getting poorer…” is a statistical sleight of hand reinforced by the notion that the economy is like a pie. The slice that the bottom 20% held in 2007 was indeed 0.3% smaller than it was in 1947. But the pie has nearly tripled in size and thus nominal (inflation adjusted) income has more than doubled. In terms of standard of living the poor are even better off. We include in the definition of “poor” even those suffering from a mere dearth of the latest goods. But such a metric is misleading. In terms of creature comforts the “poor” are better off today vs just 50 years ago (e.g. ubiquitous home air-conditioning, inexpensive TV’s, game systems, iPods, smartphones, etc). Compared to even the wealthy of a hundred or two hundred years ago the poor are living like kings – indoor plumbing, refrigeration, plentiful food, washing machines, cars, telephones, and the list goes on. Measured on an absolute rather than relative scale the “poor” in most countries are better off today than in any time in history.

Now, to the first and last point – aren’t some taking “too much” of even this bigger pie? If a few get “all” the money won’t that make everyone else “poor”? To answer this, let’s assume the most extreme case: one wealthy person amasses 99% of all the money in the economy. Surely this is a terribly “unfair” scenario that must be prevented, right? Wrong. Why? How can anything get done with so little money? Easily (in a non-government manipulated economy). In this scenario money would be in HIGH DEMAND. Demand is proportional to price, thus “money” would have a HIGH PRICE. Price is the cost of one good in terms of another good. A unit of money will cost more goods than it used to. So if $1 cost a dozen eggs then now it will cost more eggs, lets say 120. So we go from $1/12 = 8¢/egg to $1/120 = 0.8¢. What has happened? Because dollars are in high DEMAND the PRICE of dollars in terms of other goods has gone UP, whereas the price of other goods in terms of dollars has gone DOWN. This is monetary price deflation and contrary to what the Fed might have you believe it is a good and natural thing. The rest of the people in the economy can go about their business producing and exchanging as they were before simply using pennies in place of dollars. It is production of goods & services that produces wealth, not money. The amount of money in an economy does not matter and has no effect on the productivity of that economy. As long as people continue producing, they can never be “poor” no matter how much the “rich” have.

Equalization?

Equal. This simple word conceptualizes our most basic and noble sentiments: all men are created equal…equal protection under the law, etc. But, it has a sinister sibling that it is often confused with: “equalization”. This concept is the dubious notion that we should forcefully create a state of “equality” among all citizens, at least on an economic level.

But why this notion that equalization is necessary? The usual answer is that it is “bad” when some make “too much” money. However, this response betrays a childish and simplistic view of the economy, one wherein it is likened to a board game (one player wins and all others lose). This view is based on the fallacy that money itself is wealth. But, it is production, not money, that is the basis for wealth. If money were wealth then the government could just print up a billion dollars for each of us and our troubles would be over!

To illustrate the true nature of wealth let us consider two hypothetical peach farmers, let’s call them Hayek and Keynes (google the names to get the joke here). They each start with one peach tree. Each year they produce a crop sufficient to sustain themselves. After a few years of this Farmer Hayek decides to not sell all his peaches, rather he plants a few to grow new trees. [Economics lesson: the act of not consuming is called “saving”, anything saved is called “profit” and accumulated profits are called “capital”. Capital is that which is produced not for consumption but for further production.] Farmer K sells all his peaches each year and lives it up relative to Farmer H (i.e. he consumes all that he produces and does not save anything). After a few years Farmer H’s new trees start to bear fruit. After several years Farmer H has a large orchard that out produces Farmer K’s single tree. Farmer H now has many options: he can purchase any number of goods that Farmer K could never afford, or perhaps he may hire someone to manage his farm thus allowing him to retire early. His deferment of present consumption (unsold peaches) is accumulated and thus becomes capital (new trees), which makes possible greater future production.

After several years Farmer H makes a hundred times what Farmer K does. Is that bad? Should we “equalize” them by taking the “excess” profit from Farmer H and giving it to Farmer K? Is Farmer K worse off than before? No. Farmer H did not take anything from Farmer K, he simply produced more by employing the simple concepts of capitalism.

The economy is not a zero sum game. Farmer K is not worse off because Farmer H produced more. If a CEO or Wallstreet mogul makes millions or billions it doesn’t negatively affect me (or anyone else) in the slightest. They did not forcefully take anything from me (only the government is allowed to do that!) All “equalization” does is punish those that efficiently produce what other people want. So let’s keep our tax policy focused on funding the government, not on correcting ill-conceived notions of equality.