Today we are going to take a look at the different stages at which an economy can be found, their meaning and the explanations as to how these stages operate. We are also going to explain why a progressing economy is the most desirable state of events.
Before we jump into the core of this lesson, we need to define a theoretical state in which an economy can be found. The most basic scenario we can build is one in which the amount of wealth remains constant worldwide, thus the sum of all entrepreneurs' profits equals the sum of all entrepreneurs' loses. The profit of one entrepreneur must always be balanced by sufficient loses from other entrepreneur(s). This scenario was originally created as an oversimplification of reality; this much is obvious… or at least it would seem so. But is it? Although this would seem to be a very farfetched scenario it actually takes place. When? When there is a worldwide contraction of economic activities due to systemic economic debacles, such as the one that occurred in 2008. During that period there was a moment where there was exactly zero economic growth at the worldwide level. Thus, a stationary economy is also known as a stagnated economy. No worldwide net economic progress takes place. But this is not the only possible scenario. We can also imagine a scenario where the total wealth of the world decreases. We also lived through such a scenario in 2008 where the global GDP actually dropped. We call this scenario de regressing economy or a depressed economy.
However, if there is a scenario where the total amount of wealth remains constant and one where it decreases, there must also exist a scenario where the total amount of wealth increases. This is correct. This is called a Progressing Economy and it is the one that interests us the most.
As we are going to analyze economic scenarios from a perspective of an entrepreneur, we need to have a more precise definition of a Progressing Economy.
A Progressing Economy is one in which the amount of capital goods per capita (or its net total at the worldwide level) is increasing.
In other words, a Progressing Economy is the one in which there is progressively more capital being invested in capital goods. In other words, companies are investing more and more capital in activities that produce more and more goods and services. This is also known as a growing economy, not to be confused with a "booming" economy which is a direct result of Central Bank printing. A growing economy is a natural process of free markets. A booming economy is an artificial phenomenon artificially sustained through currency manipulation by Central Banks, inevitably leading to a "bust".
Regressing Terrible, Stationary Bad, Progressing Good
Now that we understand the differences between a Regressing, a Stationary and a Progressing economy, we can analyze which one is the preferred one. Let's begin with a re-statement of entrepreneurs' actions. Entrepreneurs seek to obtain profits. They seek to achieve this goal through the means of satisfying customers' needs through the creation of goods and services that customers want and are willing to pay for. Basically, no sale no profit.
In a Regressing economy, the amount of capital (or savings) is decreasing all the time because they are being used for consumption. This is, people are literally eating their savings away. As such, people are purchasing only the minimum amount of goods and services they need thus entrepreneurs are making smaller and smaller profits. These shrinking profits can only be invested in less and less capital goods which will produce less and less consumer goods. In addition, as savings (available capital) drops, entrepreneurs can't even borrow capital to purchase new capital goods, even if people would be able to afford them. Thus, in a regressing economy we have less and less consumer goods and services. But these consumer goods and services are the ones that reduce our uneasiness. Thus, as consumers we have less and less tools to reduce our uneasiness. In modern terms, we would say that our standards of living are decreasing and this is obviously terrible. This is akin to a person which has a spreading itching rash which is crippling to the point of preventing this person from scratching.
In a Stationary economy, an entrepreneur only has two choices in order to attempt to produce consumer goods and services. The entrepreneur may shut down part of its operation and re-direct this capital towards manufacturing a different set of goods and services. Or, the entrepreneur may obtain capital from lenders, which would first have to take this capital away from other entrepreneurs. As the amount of capital is fixed, only certain amount of consumer goods and services can be produced to the expense of other consumer goods. What this means for consumers is that our capacity to decrease uneasiness is fixed. We only have so many tools to reduce our uneasiness, no matter what entrepreneurs do. In modern terms, we would say that our standards of living remain constant. Obviously this is not a terrible scenario but it is not a good scenario either. This is akin to a person who has a rash on the back, this person being unable to scratch un-accessible places.
In a progressing economy an entrepreneur has two choices. This person may re-invest part of the growing profits as capital through the purchase of capital goods, or an entrepreneur may borrow from lenders providing an increasing amount of capital (i.e. savings) for investment purposes. As the amount of capital goods increases, the amount and types of consumer goods and services also increase. Which means that as consumers we have now a growing toolset from where to choose in order to decrease our uneasiness. In modern terms, we would say that our standards of living are increasing. Obviously this is the preferred state of events. This is akin to a person with an itching rash being treated with a growing number of effective medications hoping for a complete eradication of the problem.
The Progressive Economic Cycle
Now that we understand that the most desirable state of events is one where the economy is progressing, we may inquire as to the mechanism for this to happen. The definition of a Progressing Economy indicates that it is one where the global net amount of capital goods is increasing. But such an increase necessarily means that the quantity of consumer goods produced by these capital goods will also increase. If we now apply the simply rule of supply and demand, when supply increases prices drop. Which means that there are now more consumer goods at lower prices for all of us to enjoy. This implies that standards of living are increasing.
However, there is also a side benefit. This is the fact that as we spend less of our money for more and better consumer goods, we have more money left to save. But our savings are actually capital which we can lend to entrepreneurs so that they may purchase more capital goods which will generate more consumer goods which will further increase our standards of living and thus increase our savings (available capital). It is obvious that this process is a self-reinforcing one. Thus, it is obvious that the most critical part of the engine of this process is the amount of available capital for use by entrepreneurs.
The more capital there is, the higher our standards of living.
This is a profoundly important conclusion. Capital accumulation is economic progress made real through the manufacturing of consumer goods and services.
We now need to discuss yet another self-reinforcing process in a Progressing Economy. This is the process related to our purchase power. We have showed that the more entrepreneurs invest in capital goods, the more plentiful consumer goods become. As such, we have more money to save, but we don't save it all. We spend some of it. It is what economists call "disposable income". Money that we don't want to save and with which we want to satisfy other less pressing needs. Once we have enough to eat, cloth and shelter us effectively, we may want to enjoy ourselves through the acquisition of a car, a monster TV set and perhaps a vacation in Greece (before it collapses altogether). As such we consumers go out and spend part of this extra money that we have left thanks to the low, low prices already created by entrepreneurs. But when we spend this extra money we are ensuring that entrepreneurs have net profits and not net loses.
With net profits entrepreneurs do three things. They save some of this money (i.e. they create capital), they spend part of this money (i.e. consumer goods) but they also re-invest part of this money. Re-invest in what? Capital goods. It so happens that entrepreneurs now have more money than the capital already present in their enterprises. They don't have to dismantle one piece of the company to create a new line of products as would happen in a Stagnating Economy. They can purchase new capital goods thus increasing the total amount of such goods. But when they do so, they further fuel the progressive economic cycle.
So far we have shown how the progressive economic cycle works. Now we need to show how new capital goods can be acquired. It so happens that there are only two ways to do so:
- Expand manufacturing
- Create new technology
The first way is simple enough to understand. If an entrepreneur wishes to have a higher manufacturing output all this person needs to do is to expand the production line. Instead of having two marble making machines the entrepreneur purchases a third one and then a fourth one and a fifth one and so on. All these machines are identical but there are more of the same. More machines means more marbles.
The second way is to purchase new and improved marble-making machines which can make marbles using high energy lasers directly from sand as opposed to polishing chunks of glass like previous machines. These new machines are faster, more efficient and cheaper to operate than the previous machines.
The net result of either path is that the amount of capital goods increases and thus the amount of consumer goods increases while the price of said consumer goods decreases concordantly (yes, we stole this last word from The Matrix Reloaded, like it?).
Note: please see the Glossary if you are unfamiliar with certain words.