Thursday, April 16, 2009

Thoughts on the Economic Crisis, I

It's a financial crisis!
It's an economic crisis!
It's a failure of unregulated capitalism!
It's the end of the Reagan Revolution!
It's the worst since the Great Depression!

All of the above are statements one can hear describing the current economic situation. The use of the term crisis indicates that we are in a situation that is not normal. The third statement indicates that capitalism as practiced in the U.S. (as well as the U.K.) has failed because of lack of government oversight and regulation. The fourth statement suggests that the Reagan Revolution brought in unregulated capitalism and this has failed. The last statement is ubiquitous, but also indicates that things are really bad with the suggestion that things may get worse.

I want to examine things from a different perspective. Actually, I want to begin with Adam Smith and the key idea that specialization of labor is productive. What does this mean? At a minimum, it means that most of us produce goods or services that we do not consume or utilize and consume goods and services that we do not produce. This specialization is productive so that we can have much higher standards of living than if we were totally independent. In fact, most of us probably wouldn't survive long if we could only consume and use goods and services that we produced ourselves.

There are costs associated with specialization of labor. For one thing, the actions of different people need to be coordinated. If I don't make my own food, I have to rely on others to do so. All the things produced by producers are meant for consumers and the goods produced need to get to the consumers. The wants of consumers have to be communicated to the producers. Further, a form of exchange is needed. In a very simple economy, barter can be used. Another possibility is to have someone responsible for collecting all the goods and distributing them to the members of the simple economic system or society. When humans were organized in small tribes, this method may have been used. But, as societies get larger and specialization of labor gets more complex, these simple methods don't work well. Some medium of exchange--money--is needed. Adding money to the mix also adds complexity and potential problems. Is the quantity of money appropriate for the number of transactions that will be made. Who is responsible for producing the money? Who determines what money is? More questions could be added.

Another complicating factor is that we live in a world of space and time. Production takes time, whether we are talking about planting corn in the spring and harvesting it in late summer, or building a house. Further, some goods we produce are durable and provide services for a long period of time. Some goods are produced to increase future production but not for consumption. These investment goods include most of the capital goods in factories. A decision to start a firm to produce pencils involves purchasing inputs from many different parts of the world, building capital goods that are used to perform many of the steps in pencil production. (A description can be found in the interesting book, The Pencil: A History of Design and Circumstance by Henry Petroski. Available at Amazon.) To start a firm making pencils requires spending a lot of money to obtain the needed inputs, capital goods, and to support oneself while waiting to obtain revenues from pencils that will be sold eventually. This is where finance comes in. The people with the entrepreneurial spirit to start a new firm, the ideas that may be commercially viable are not always people who have savings to live off of while the plans come to fruition. Financial markets transfer funds from savers to investors. But, the investor may or may not succeed. The investor is counting on people wanting to buy his or her product in the future for prices that will cover all of the costs incurred by the investor. The future is unknown. Hence, many investment plans fail. Many new firms fail.

Given these complexities associated with specialization of labor and time, it would be easy to think that we would have chaos unless some very wise people were consciously and actively coordinating everything. That is, isn't it inconceivable that hundreds of millions of people can make decisions on their own about what to consume, where to work, what to make, what to save and invest, how many children to have, etcetera, etcetera, etcetera, could actually function? From this perspective, any situation that is not an economic or financial crisis would appear to be the abnormal situation. We should always be in crisis.

I will elaborate further in a later post.

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