Macroeconomics for Dummies

Macroeconomics for Dummies Page 1

Macroeconomics for DummiesC 2003 Abridged 2009

Gower D. Talley MBA

The Northwest Boardroom

www.thenorthwestboardroom.com

The paper, Macroeconomics for Dummies, was initially published in 2003. It was referred to in my book 5 Things I learned on theRoad to the Dream and has been requested by several readers of the book. This is an abridged version. I reproduced it because thepublics understanding of even the most basic economic principals seems to be even poorer today. This paper addresses the basicconcepts of wealth creation and consumption from a laymans perspective and illustrates why government spending does not haveeven the hypothetical potential of growing the economy.

Government controlled collective economicsbased on some arbitrary standard of fairness hasfailed every single time it has been tried. Thereare absolutely zero historical exceptions. Thelargest experiment in collective economics (thecommunist government of the Soviet Union)imploded under the weight of its own failedeconomy. Even the tiny experiments (thecommunes of the 60s) have largely beenabandoned. North Korea is economicallyimploding as we speak, they have a per personaverage yearly income of less than $800. (And bythe way, North Korea is almost identical in almostevery way except governmental-economic form totheir neighbor to the south, which is a thriving,almost western country.) China is moving towardmarket capitalism as fast as it can to avoid the samefate. The concept of from each according to hisabilities, to each according to his needs, theconcept of government redistribution of wealth andresources based on some more noble set ofcriteria, is fatally flawed.

Socialism, if clung to till the last, has alwaysresulted in total bankruptcy. Always. Despitepeoples best intentions, eventually, there is no

wealth left to redistribute. And yet, experimentscontinue. There seems to be a continuing belief thatthis time will be different. Undeterred by the factthat one cannot find a single historical success topattern a new experiment in sharing andfairness by, we have another go at it. We takefrom those who have too much and give to thosewho have too little. And again, if unchecked,there will eventually be nothing to take and nothingto give. The well meaning among us are leftwondering who is to blame and wondering whytheir noble attempt failed again.

The intent of this paper is to explain why.

The short answer is that socialism, even limitedor partial socialism is simply impossible. Notdifficult, not complicated it is at its core,mathematically impossible. It defies the basic lawsof economic physics. It is an attempt to build aneconomic perpetual motion machine. It assumesthat the business engines that produce great wealthwill continue to do so, every bit as energetically,even as we systemically confiscate their resources,even as we slowly take away the reasons businessventures began in the first place. It also assumesthat government systems to redistribute those


confiscated resources will be frictionless andperfectly efficient. These concepts: the indefiniteconservation of momentum, perfect efficiency, andthe complete elimination of friction, are asimpossible in economies are they are inphysics. Just like a perpetual motion machine, asocialist economy will eventually come grinding toa halt under its own weight.

Unfortunately, these seem to be difficultconcepts to convey to the American public at large.The concept of wealth creation in business is adifficult one to wrap ones brain around. Theunderstanding of what wealth actually is and whereit comes from is just as complicated. It is just tooeasy to see those who have too much and seethose who have too little and believe the thing todo is spread the wealth around a little.

There are those in our government who supportsocialism, in one form or another, who alreadyunderstand everything we are going todiscuss. These people support socialism withoutbelieving in it. They change its name (progressivehas a nice ring, doesnt it?) and then seek toconvince you and I of things that even theythemselves dont believe. There are a variety ofmotives for this, none of which I am going toaddress here in much detail. Socialism can allowpeople in government power over wealth and assetsthat they would never earn, or earn the right tomanage. Socialism is a great political tool individing and conquering.

You poor, poor thing! See that mean ol guywith too much stuff over there? That just isnt fair,is it? Some of that stuff should be yours, shouldntit? Wait right here, Ill go over there and get it foryou! Now Im your hero, arent I? Vote for me andIll get you more stuff!

This paper is not written to address thesepeople. Perhaps at some point Ill write on the artof promising to use political power to give yousomeone elses stuff, but that is not my intenthere. This work is directed toward the truebeliever. My point is to begin the process ofshowing those who actually believe that socialismcan be made to work, why it is flawed to the point

of mathematical impossibility as an economictheory and to do so in a reasonably palatableway.

The economic birds and the bees: (Daddy wheredoes wealth come from?)

Wealth CREATION We will start with themath part and get that over with. This really isntvery complicated at all. You wont even need yourpencil and you can leave the calculator in thedesk. Lets look at a business equation. Lets saythat I am a building contractor. I am abusinessperson who contracts the building of homesand then sells them. Lets say that I purchase a lotof land for $50,000 and that I pay fair currentmarket value for the land. I purchase buildingmaterials for $50,000 (again, at fair market value)and that I hire carpenters at their fair market valueand that they are paid a total of $50,000 for theirefforts. Lets say that this activity builds a homethat is worth $200,000. I sell the home for$200,000.

Land $50.000

Materials $50.000

Labor $50.000

Total $150.000

Sale Price $200.000

Profit $50,000

Dont worry, this is not an exercise in basic math,we are coming to a very important point:

The $50,000 profit in this equation is createdwealth - it is new money. It was not transferred tome by anyone else; this $50,000 did not exist at all,in any form at the beginning of the equation. It isnew wealth in the economy; it is what is meant by


economic growth. It is not simply a profit madeby transferring resources to myself from elsewhereby buying something at less than its value or byselling something a more than its value. It is notmerely buying at wholesale and selling at retail, it isnot merely making a commission. This is the actualcreation of new value, of new wealth. Absolutelyeveryone involved in this transaction profited. Eachof the players in this equation received full value fortheir sale, purchase or labor. No one lost so that Icould win. The original land owner and lumberyard owner received full, profitable, value for theirsales. The carpenters received full value for theirwork, and the person who paid $200,000 for thehome, still has an asset worth $200,000. Theysimply traded a liquid asset (money) for a tangibleasset (the home). They could (and at some point,probably will) trade again. In fact, that asset maywell increase in value while in their possession.

$150,000 in resources was assembled in such away so as to create a $200,000 asset.

Not only did my bank account grow by $50,000,but, because the money was not transferred to mefrom elsewhere, it was created by my activity; theentire economy grew by $50,000 as well. This, in anutshell, is how wealth creation works. This iseconomic growth. This is the engine of oureconomy.

Wealth Creation is an economic transaction wherethe sum of the wealth at the end of the transaction isgreater than the sum of all the wealth invested in thetransaction.

At the heart of all collective economics is themisperception that economics is a zero sum game,that there is a fixed quantity of wealth and that alleconomic transactions are simply movement ofwealth from one place to another. Socialists believethat for one person to profit, another mustloose. Socialists believe that it is theirresponsibility to redistribute the finite quantity ofwealth according to a more fair standard of theirown making.

As we discuss wealth creation, it is important totouch on what wealth actually is. It is important

not to confuse actual created economic wealth withphysical resources or currency. A country cannotbecome rich just by printing more money. Moneyitself has no value. Paper dollars (or electronicdollars) are only a store of wealth, they are justscorecards, they are not wealth it self. Money isjust a convenient way that societies have invented tostore and exchange value that has been created inthe economy. Having a paper dollar in your pocketis only one, of many ways for you to have adollar. When value is created or lost in theeconomy, it does not mean that currency is printedor burned. Money, be it paper or electronic, is onlyone of many types of stores of value in oureconomy.

Building on that concept, here is an even morechallenging one. Tangible things, things that wouldseem to be vested with value in and of themselves,are also just stores of economic value. Evensomething as seemingly tangible as food is only astore of units of value within an economy. Letslook at an example. Lets say you are a carrotfarmer. After harvest, you have 100,000 pounds ofcarrots. Their initial value to you is that you can eatsome of them. Quickly, however, you will have allthe carrots you can consume and they will have nomore value to you in that form. Next, perhaps, yourneighbors would like to eat some carrots, andperhaps they have something you would like inexchange. Your carrots value in that form endswhen your neighbor has all the carrots he can eat, orwhen you have all of whatever he is trading forcarrots that you want. As you can see, this type ofdirect barter stops being practical very quicklywhen one is looking at any significant volume oftrade. The real value of your carrots is the valuestored in them by the economy as a whole, and theability of the economy to transition those carrotsinto a car payment or baby clothes. In a stable, freeeconomy you can exchange the value in yourcarrots for things you want with people thousandsof miles away, who you will never meet who maynot even like carrots. (Typically, this exchange isaffected by exchanging your carrots for a currency,and then exchanging that currency for the thingsyou want.) If the economy placed no value in yourcarrots, they would be worthless, beyond yourability to eat them or directly barter with them. If


the economy looses value, so do your carrots. If theeconomy gains value, again, so do your carrots.

In the great depression of the 1930s, piles of foodrotted while people 200 miles away starved. Thegreat depression was not a lack of resources; it wasa lack of economic value in those resources. Thedepression was not a lack of stuff; it was acollapse of the ability to exchange stuff for otherstuff. It was a loss of created wealth in theeconomy as a whole. People had carrots and peoplewanted carrots, there just wasnt value in theeconomy to make the exchange. Carrots stoppedbeing worth the time and gas it took to grow themand get them to market.

The strength of a national economy is based lesson the amount of stuff in that country than it isbased on the ability of stuff to absorb and transfereconomic value in a consistent and predictableway. Many of the poorest countries in the worldhave lots of resources, in some cases more than theyneed. They just dont have economies that canprocess, transfer or absorb thoseresources. Resources rot or collect dust just downthe road from where those same resources aredesperately needed. In many cases, Americans sendemergency food shipments to countries that havefood or the ability to produce food. Very often, theissue is that the economy of the receiving country isso weak and unpredictable that it is more costeffective for us to fly food 3000 miles than it is forthem to grow, harvest and process food and put iton a truck and drive it 50 miles. These countries arenot poor in stuff, they have stuff or they couldmake stuff. They are poor in economically createdwealth; therefore their own stuff is worthless tothem.

Lets return to our wealth creation example andflesh it out a little. Not only did our real estateinvestment create $50,000 for me directly (that willfind its way in to the economy, both in the form ofmy consumption spending, and in the form of otherwealth creation projects), but everyone involvedgained as well. The lumberyard owner, who soldme the supplies, sold them at a profit. I created ajob for the carpenter who will then go out and spend

the money buying groceries and having hiscoveralls cleaned. The economy actually grew byeven more than the $50,000 in our originalequation.

If we were in a classroom, I could see the handsin the back of the class. I am sure that there arethose who are shouting at this page that in ourexample it is the carpenter, the individual worker,who actually created the wealth, not thecontractor. This, in fact, is a key premise ofsocialism. It is, however, not at all true. Ourcarpenter cannot wake up in the morning, go out,find a pile of lumber in the street, nail boardstogether indiscriminately and expect that moneywill fly into his pocket. The wealth was producedby the project itself. Our carpenter was offered aprofitable role in our contractors wealth creationproject. Our carpenter could exert those sameefforts elsewhere with no gain at all. The carpenterdid the work, but the contractor enabled the work tobe financially productive.

Three things are required to create wealth:

A Plan Someone must envision a way that wealthcan be invested so that at the end of the day, thewealth has increased.

Investment the wealth must be obtained to invest

Risk There is almost never security above awealth creation project. Because wealth creation isthe top of the economic food chain, there is no oneto appeal to for fairness or justice. To create wealth,one must accept that if the plan fails, one willloose. There will be no one to appeal to.

These are the differences between a wealthcreating entrepreneur and a wage-earningemployee. The key among these differences isrisk. Wealth is created at the point where wealth isrisked. Our carpenter will expect to becompensated even if the wealth creation projectfails. If the bottom falls out of the housing market,and my $150,000 investment produces a houseworth only $100,000, our carpenter will still expect


to be paid. A big part of our carpenters salary isinsulation from the economic risk associated withthe project he is a part of. An employee iscompensated based on efforts expended. If anemployee does what he is told, he iscompensated. An entrepreneur, on the other hand,is compensated based on accomplishment orsuccess. It does not matter how hard theentrepreneur tried, it doesnt matter how mucheffort was expended, the plan has to work. If theplan fails to be productive, his fault, someone elsesfault or no ones fault, not only will there be nocompensation, but the investment may be lost aswell. The difference between an employee of awealth creation project and partner in a wealthcreation project is that employees do not typicallyshare in the risk of loss.

Consumption Economic transactions for therest of us.

The reason that the concept of wealth creationseems so arcane to most Americans is that it rarelyhappens in their direct field of view. There is acharacteristic about a wealth creating transactionthat doesnt exist in the vast majority of ourpersonal financial transactions. For a project to bewealth creating, both sides of that transaction mustcontinue to have economic value after thetransaction. (In our example, the two sides are: thehouse created by the contractor and the moneybrought to the table by the new homeowner.) Bothmust be vehicles to continue to move the wealth itstores through the economy. The reason I chosereal estate for our example of a wealth creatingtransaction is that real estate is one of the extremelyfew examples of something that we (typicalconsumers) might purchase that will (or at leastcould) continue to move our wealth through theeconomy. Most wealth creation is at the upperlevels of business and is multi-step and extremelycomplicated. The vast majority of our spending (usnormal people) is consumption, not investment, notwealth creation.

Most of the time, when you and I make apurchase, the economic value of our purchasedeprecates to zero while in our possession. Most ofwhat we purchase ceases to be a vehicle for the

movement of wealth at the moment we acquireit. This will be a lot easer to understand with anexample:

For comparison, lets look, one more time, atour real estate wealth creation transaction:

o Our contractor brings a $150,000 investmentto the table, and he uses that to create a$200,000 asset.

o Our future homeowner brings $200,000 tothe table and purchases the home.

o At the end of our transaction, the contractorhas $200,000 that will continue to movethrough the economy and the homeownerhas a $200,000 asset that will also continueto move through the economy as it is resoldor borrowed against.

o $350,000 came into this transaction from theeconomy and $400,000 left this transactionand continued moving through theeconomy.

o More wealth came out of this transactionthan went into it and then all the wealthcontinued to move.

Now, lets look at what the rest of us do. Lets lookat a consumption transaction.

I go to the store to buy a box of disposablediapers. I take $10 boxes of diapers cost$10. The storeowner and I each come to the tablewith $10 assets. The storeowner and I exchange our$10 assets, now I have the diapers and he has the$10 bill. O.K. folks, watch this, this is theinteresting part. Once I put the diapers in my cart,their economic value immediately becomeszero. This is now $10 in wealth that is no longermoving in the economy. The diapers will be useful,but not in an economic way. They will go on mybabys butt; they will not go back into theeconomy. I will not sell those diapers. The box ofdiapers stops representing a store of $10 in value atthe point I place them in my shopping cart. Iexchanged one store of $10 in wealth (a $10 bill)for another (the diapers) and at that point the wealthis consumed. The diapers were a $10 asset asthey set on the shelf; they ceased to be so as soon asthey came into my possession. The $10 bill I gave


to the store will continue to move through theeconomy, but that is only half of the wealth broughtinto this equation. $20 came into this transaction;only $10 came out and continued to move in theeconomy. This transaction consumed half thewealth that went into it.

In a wealth creation transaction, more wealthcomes out of the transaction than went in.

In a wealth consumption transaction, less wealthcomes out of the transaction than went in.

For an economy to grow,wealth must be created faster

than it is consumed.Most of us are consumers the wealth

creation process is not something that we often seedirectly. Most of us receive our wealth severallevels down from where it was created. Most of usare something like a piano teacher, who was paid bythe laundry owner, who was paid by the carpenterwho was paid by the contractor who created thewealth. The wealth comes into our possession; weconsume it (by purchasing diapers, milk and pizza)and look back up the chain for more. We receivewealth, several levels away from where it wascreated, we spend it and it is gone. It is very easyfor us to assume that this is the way that alltransactions work. It is easy to assume thatcorporations and very wealthy people are justpeople and organizations with more money to spend,more money to consume. The truth is that verylarge sums of money are rarely spent orconsumed. Seven figure sums are not ofteninvolved in consumption transactions. Seven figuresums are traded for other seven figure assets, whichare again traded. Very large transactions are almostalways investments, where the wealth on both sidesof the equation continues to move. At the very topof the economic food chain are wealth creatinginvestments where not only does the wealth on bothsides of the equation continue to move, but also itactually grows in the process.

You have heard the expression follow themoney. I would ask you to change that to followthe wealth. Money is just one store of wealth you can be rich without having much money if youhave other stores of value. You can follow thewealth by watching the transactions. Watch wealthas it moves from where it is created to where it isconsumed. If you only look at currency, at dollars, itcan seem that economies are circular. The truth,however is that our economy is a simple linesegment. Wealth moves from point a, where it iscreated, to point b, where it is consumed. The sizeof our national economy is the amount of wealththat exists between point a and b at a specificpoint in time. For our economy to grow wealthmust be created at point a faster than it isconsumed at point b.

And now folks it is brass tacks time. Here is ourfirst look at a critical point. Here is the fundamentalreason that socialism doesnt work. Are youready? Here goes:

Wealth has never, is never and couldnever be created by or through

government. Government is only aconsumer of wealth, and it is the most

inefficient consumer of wealth imaginable.

Government is one of the only places where 7, 8and even 9 and 10 figure sums are actuallyconsumed. When government attempts to makethings more fair by transferring wealth andresources from one place to another, this transferprocess consumes far more than itredistributes. There has never been agovernmental spending action that has not been anoverall negative influence on a nationaleconomy. In absolutely every case, when we placegreat wealth in the hands of government, most ofthat wealth goes completely away consumed bythe friction of the redistribution system - before itagain finds its way into the hands of any privateindividual.

It can be argued that we should take somegovernmental spending action to help our mostvulnerable citizens. We live in the most prosperous


nation in the world, we should not let our peoplestarve in the streets if they do not have the means toprevent that and we, collectively, do. There are alsoa limited number of other things (such as roads, lawenforcement, national defense, etc.) that we as acivilized people need, that are difficult toaccomplish out side government. We must,however, understand how enormously expensiveany type of government action is. We mustremember that every dime consumed bygovernment had to be created in the privatesector. We must remember that every dimeconsumed by government will no longer beavailable to create new wealth. The business ofproviding routine necessities of life throughgovernment distribution systems to a large segmentof the population is an incredible drain on thestrength of a national economy. The process oftransferring wealth through government isinefficient in the absolutely ridiculousextreme. Providing someone with a $13,000 a yearfood stamp type existence through governmentcosts at least $50,000, taxed from the privateeconomy.

Government transfer payments always havea weakening effect on the economy as awhole. Always. The person who receives thetransfer payment benefits personally short term,but because of the enormous administrative costassociated with the transfer process itself, theoverall national economy is always weakened. Onecould argue that in some cases, helping individualrecipients who are in great need is worth theenormous cost and the damage to theeconomy. That is a subjective evaluation and Illleave that to you. However, the argument that anyprogram of government wealth redistribution couldbe positive to the economy as a whole is simply,logically, false. Those who propose stimulatingthe private economy with government moneyseem to forget (unintentionally or otherwise) thatthe government does not have any money of its own.For the government to insert money into theeconomy it must first extract money from theeconomy. The administrative costs associated withextracting and redistributing those resources grosslyexceeds any potential return those resources mightearn in their new, government mandated home. The

vast majority of money taxed for the purpose ofredistribution simply vanishes. The apparatus ofgovernment always consumes far more than itoutputs.

When government touches private resources, mostof those resources are consumed and the parenteconomy shrinks. Every time.

Macroeconomics for Dummies

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