How Wealth is Created

How is wealth created?  Well, I guess I would say it's when a person or business produces a good or service.  The more goods we create, the wealthier we all are as a nation.  If wealth is important to you then it should be our goal to maximize wealth creation and minimize wealth destruction.  Fortunately, it's not really that hard.  History shows us that 90% of the job is done for you by the "invisible hand".

Adam Smith described the necessary components of wealth creation as: "materials, labour, land, and technology in such a way as to capture a profit."  Economists later called these things the "Factors of Production" and they haven't really added much to the composition left.  It's still land(natural resources), labor, capital(materials and technology), and most add in the all important entrepreneur who brings it all together.  Doing a quick google search this doesn't appear to be in contention (see here, here, here, and here).

So that's how wealth is created, an entrepreneur gets access to capital, buys the materials he needs, hires people to do the work and then they start making stuff.  They make more stuff than they need and they sell it to people who need it.  Cars, boats, cell phones, it all comes down to bringing these things together and wealth is made.

It's not really magical when you look at it like this, but it certainly seems that way when looking at all of it put together.  In terms of history, capitalism has been the most efficient way to create wealth.  It's obviously better than serfdom where the lord and lady tell you what to make.   Communism proved to be only slightly better than feudalism, but I think it's only because they still used money and gave the Czar's wealth to the rest of the people.  I don't think capitalism is perfect or infallible, but in terms of wealth creation, it's yet to be beat.

Jon Stewart Must be Reading This Blog

Wednesday morning I wrote about how ridiculous it is to fight over non-security discretionary spending in order to "balance" the budget when it only accounted for 13% of the budget last year. Then, later that night, Jon Stewart did a little skit pointing out the exact same fact. You can watch the video below(the important part starts at 3:45) or just read the transcript below the video.

The Daily Show
Tags: Daily Show Full Episodes,Political Humor & Satire Blog,The Daily Show on Facebook

You know what? It's clear that none of you guys, Republican or Democrat, are taking this seriously. I'm going to do it myself. I'm gonna go Charles Grodin in Dave on your ass.  And that is my last reference for the night.  All right, how big is the budget?

GWEN IFILL: President Obama's budget proposal for the next Fiscal Year came in at more than $3.7 trillion.All right, $3.7 trillion.

What's the deficit?

BILL O'REILLY: The deficit, $1.1 trillion.

OK, so it's... you know what though?  Hold on.  Yeah, that's better.  Sometimes they need to warm up.  All right, so we got $3.7 trillion up for grabs.  How much...?

AL HUNT (2/16/2011): 88% of the budget is not affected by these cuts. ... They are only focusing on the cuts on 12% of the budget.

Oh, so we can only cut from 12% of the budget?  All right, well, 12% of $3.7 trillion is... $440 billion.  So here's what we need to do.  We need to get $1.1 trillion of spending cuts out of $440 billion. So I'm just going to very quickly, um... Watson?  Watson??

That's all the proof I need to be convinced that he reads my blog :) Now hopefully he'll keep reading, and he can learn that the federal budget is constrained by inflation, not revenue. If so maybe he can find a hilarious way to show why all this deficit hysteria isn't a real issue.

The difference between Wealth and Money

Economically speaking, what is the difference between wealth and money?  Here's how I look at it.  Wealth is all of the valuable goods and resources that you want in the world.  Whether it's a gallon of gas, or a video game, both are examples of things that people desire andor use.  Money is worthless pieces of paper and even more worthless numbers in a computer.

Looking at an entire economy, wealth is a measure of all the goods and services produced by that economy.  Those include any goods anybody was willing to pay for.  Such as: cars, homes, bread.  It also includes any services anybody was willing to hire.  Such as: Medical, education, and fixing broken goods.  Money, on the other hand, is still worthless pieces of paper and even more worthless numbers in a computer.

Wealth is what we desire: goods and service. Money is a tool we use to exchange those goods and services between each other. The point of this post to acknowledge the difference between the two. Giving everyone more money does not necessarily result in everyone getting more wealth. The wealth is created when people start trading that money with each other in exchange for more goods and services.  So money changing hands can create wealth, but the act of having money doesn't do it.  Some people hoard money to obtain future wealth.  This is a bad idea because unless it is earning interest, the money will lose value overtime due to inflation.

The biggest thing that I want to emphasize is that money is a tool, and is not a typical commodity.  Granted, it sometimes behaves like a commodity, but it has no intrinsic value.   Creating wealth should always be the goal, and money should be seen as nothing but a tool used to achieve that goal.

Balance the Budget with Non-Security Discretionary Cuts? No way!

All of Washington is buzzing about the release of competing budget plans to cut the deficit.  The whole thing is a bad joke.  Last year's budget deficit was over 1.4 trillion dollars.  If you would've told me that last year I would've thought that was a major problem.  However, now I realize that federal spending is restrained by inflation, not revenue.  Don't get me wrong, I look at the size of the budget deficit with angst, but it's because I view it as a symptom of an anemic economy, not necessarily as a problem in of itself.

Unfortunately, everyone in Washington thinks the budget deficit is the problem and are trying to eliminate it through spending cuts(this is in spite of the massive tax cuts passed late last year).  In his state of the union, President Obama promised to freeze "non-security discretionary spending" over the next five years.  In his latest budget proposal he went further and cut non-security discretionary spending.  I guess he thinks there is no waste to be found in the various defense budgets.

This is where we get to why this whole thing is joke.  Let's pretend for a moment that I actually care about the size of the federal deficit and want to reduce it.  So far, President Obama is concentrating entirely on non-security discretionary spending.  I pulled up the report from the 2010 public budget database, and crunched some numbers.  Check this out.

(click here if you don't see the image above)

Do you see that?  In 2010, non-security discretionary spending only accounted for 13.2% of all spending.  That's only $477 billion.  So even if you cut out all non-defense discretionary spending, the budget deficit would still be nearly a trillion dollars.

So what about the Republicans.  What about their plan?  The house republican plan cuts 100 billion dollars.  81 billion of it is from non-security discretionary and 19 billion from security discretionary.  Even though it's a baby step better, it's still laughable if your goal is cutting the budget deficit.  81% of the cuts comes from non-security discretionary spending, while 19% comes from the much larger security related discretionary spending category.

Both of these plans are such jokes and do very little to put a real dent in the budget deficit.  Even if both parties got real and started talking about cutting the defense budget's they'd still have a rough time trying to balance the budget.  See that big red blob in the chart?  That's Mandatory spending and it's approaching 2/3 of total federal spending.  Inside of mandatory spending are things like social security, unemployment insurance, food stamps, and many other programs.  These are all programs that exist and will continue to pay out even congress and the president pass neither a budget nor a continuing resolution to fund the government i.e. a government "shutdown".

A real plan to balance the budget would involve cuts to non-security discretionary spending, drastic cuts to defense spending, and painfully deep cuts(30% or more) to mandatory spending, and the most unthinkable thing: raising taxes (gasp!).  Of course, if they actually did all these things it would probably be disastrous to our economy.  One more reason why I think this budget deficit hysteria is a bad thing.  In the end, the budget deficit will be reduced in the same way that it's always been in the past:  An improving economy moving people off of the unemployment and food stamp lines and into jobs that turn them into tax payers.

We Save When the Government Spends

As you know, for you to save money, someone else must go into debt.  As i explained last time, if 300 million people save one dollar, than one person must go into debt 300 million dollars.  One person who could do this is the federal government.  So if the entire private sector wants to save money, the federal government can be the entity that goes into debt.  In fact, the total savings of the private sector cannot go up unless the federal government goes into debt.

By total savings, I mean that if you add up how many dollars everyone has and then subtract the total amount everyone owes.   Since all money is created as a debt, this will net to 0 dollars.  However, if you pull out just one entity, say the federal government's treasury, then you can say that one entities debt must equal the others savings because eventually it all must equal zero.  That's why federal debt equals private saving.  In fact, I understand that most economics students learn this their first year of study.  Macroeconomics 101 teaches that government deficits = private savings.  This doesn't appear to be a secret.

A couple caveats about this.  I've used the term "private sector" pretty broadly here.  I've taken it to mean everybody except the federal government.  Most people further divide up the private sector into foreign entities and then domestic private sector.  It still doesn't change the fact that for these groups to save money, then the federal government must run a deficit.  Again, this is something economists already know.  They learn it as a math equation:  federal income + foreign income + private domestic income = 0.

Another caveat is that this only works for total dollars in the economy.  Some people try to dispute this concept be getting other assets mixed up with money.  An example might be that someone might be in debt, but they have a house that is worth the amount of their debt.  That is a good thing because it increases their networth, but it does not increase the amount of actual money that they have.  Somebody else, like the federal government, will have to go into debt for that person's amount of money to go up.

So what is the point of all this?  The point is that if we want the private sector to save money, we must be prepared to let the federal government run budget deficits.  It is the only way that the total savings of everyone in the country to go up.  It also means that for anyone calling on the government to balance it's budget, they are also calling for everyone else to start spending every dollar that they make.

Think of the consequences of this:  For the federal government to have a balanced budget, and for everyone to save money for their own retirement, everyone who is young must go deeply into debt.  While a system such as this is theoretically possible in a free market, it doesn't seem like it would be very stable.  Another consequence is that for the federal government to run a budget surplus, the private sector has to spend more money than it makes.  Think about that.  If you thought budget deficits are unsustainable, budget surpluses are even more unsustainable because the private sector has to sink into debt for them to happen.

Therefore, anyone who advocates for balancing the federal budget is also arguing for the private sector to stop saving money.  Anyone who thinks the private sector should save money, must also be for the federal government to run budget deficits if they are to remain consistent.

Anyone who advocates that the private sector needs to save money and that the federal government to balance it's budget is arguing for two mutually exclusive goals.  And yet, this is what politicians and think tanks on both sides advocate for.  While they all have different ideas how to achieve both, I don't think many of them realize that they are mutually exclusive goals.  Back in 1999, they were patting each other on the back for balancing the budget at the same time op eds were being written that excoriated Americans for having a negative savings rate.  Now it's the opposite.  We're thrilled that the private savings rate is so high, at the same time politicians are trying to figure out ways to lower the federal budget deficit.  If politicians and media know that these two goals are opposed, they sure don't act like it.

Reasons Budget Deficits and Inflation Don’t Always Align

In a recent post, I pointed out that government spending is limited by inflation, not revenue.  You might ask, "so what?  don't federal budget deficits and inflation rise together?"  Well, not necessarily.  There are times when other conditions can affect inflation other than the federal budget.

Currency Destruction: If physical currency is destroyed or lost, that means it can no longer be used.  That results in less money in circulation.  Since there is less of it, it means the value of it rises.  If money is more valuable, then prices drop which means deflation.  Therefore, if someone just burned a whole pile of cash it would cause deflation.  Since only 6 to 7 percent of our money is physical  currency, I doubt this would ever happen in a large enough amount to have a measurable effect.  However, some of the following items will.

Personal Savings: People hoarding cash has the same deflating effect as destroying cash.  The only difference is that eventually the cash will eventually be brought back into circulation.  However, until it is brought back into circulation the effect is deflation.  Whether or not the cash is hoarded by putting it in a cookie jar at home, or by putting it in the bank, it can cause deflation.

Confident consumers can have an effect on inflation.  If a lot of loans are taken out it creates a lot of bank money.  This can have an inflating effect completely independent of any federal budget deficits.

A financial bubble or a bubble in any other sector of the economy becoming overly inflated can have an effect on the over all inflation rate.  While the bubble is forming a lot of extra bank money is pumped into the economy, inflating the supply of money.  Then, when the bubble bursts a lot of people default on their loans and that bank money disappears which causes deflation.  Both of these things can happen independently of any budget deficit or surplus.

Notice that all of these are things are results of decisions by consumers and decisions and cannot be directly controlled by federal spending decisions.  In other words, to keep inflation low and steady requires government policies to react to the private market.  Right now that mostly happens with the fed controlling the interest rates, but that doesn't mean there aren't other inflation regulating options out there.