Sunday, April 6, 2014

Economics 1.0

Economics is tricky. It’s an old joke which I have used before, and I’ll use again, that if you ask 5 economists a question, you’ll get 6 different answers. There are several reasons for this, and one of the main ones is that economics depends on people, and people can be perverse, unpredictable, and just plain awkward.

But there are some fundamentals to economics that are not too difficult to understand, but many (I’m tempted to say most) simply do not. And the reason for this is that these principles are in some ways opposed to common sense.

There are myths about economics which you often hear people say, and I will try and explain here why the main one is incorrect.

Myth: “You cannot continue to have increasing economic growth in a world with finite resources.” Sounds reasonable, but it is not.

First, let’s talk a little about the magic mnemonic GDP (Gross Domestic Product). This is almost always the number that is mentioned when economic activity or growth is discussed. Roughly speaking it measures the amount of economic activity in a country. It does have one quite large snag though: it doesn’t measure the ‘black economy’ – activity that is under the radar because it is not recorded, and does not attract taxation. The black economy can be anywhere between about 5% and 50%, or more. The average is supposed to be about 13%, but this is a bit of a guestimate.

Also, GDP grows as inflation grows, so this has to be taken into account to get a realistic figure.

In fact, it is usually the rate of increase (or decrease) in GDP that is quoted – currently around 3% for the UK, 7% for China, so the absolute GDP value is arguably of less interest.
So there are 3 separate ways in which GDP grows (apart from inflation), the 3 steps to economic heaven J

1   1.    Increase in population
2   2.    Trade and Commerce
3   3.    Productivity and Technology

Let’s look at these in turn.

1.         Obviously, if there are more people in a country, there is likely to be more GDP. This is why GDP per head of population is often used to compare economies, though of course it depends on what you are trying to analyse. GDP of the US is around $16 trillion, that of China is around $8 trillion (2012), but China’s population is about four times that of the US, so GDP per head in the US is around 8 times that in China. But there is (probably) a limit on how many people can live in a country, so GDP growth by this means is limited. Note that this kind of growth does imply an increase in the use of resources – more people, more food, more energy, more goods.

2.         This is the tricky one. Economics is not a Zero Sum Game. This sounds technical, and it is a bit. It comes from something called Game Theory. When I was about 16, I got a book out of the local library called ‘The Theory of Games and Economic Behaviour’, by Von Neumann and Morgenstern. John Von Neumann was a prolific mathematician and general mover and shaker. He did seminal work in computing and quantum mechanics as well as game theory. The book was above my technical abilities and determination – it was a big book, and I soon took it back. Thankfully, there is a simpler way of putting this idea which many people are familiar with – a Win Win. The point is that an economic transaction can benefit both parties (individuals, companies, nations); so that both are better off than before. This may not be obvious, so let’s have a look at a very simple example.

Consider a small island with 2 men on it, separate from each other. The first man keeps chickens, and lives on a diet of chickens and eggs. He has all he needs, and a surplus is no use to him – he can’t keep it, and doesn’t need it. The second man grows corn. He keeps a small surplus to plant next year.

Now one day they meet, and arrange a trade of one chicken and a basket of eggs for a sack of corn. Both are now better off, they have a much improved diet, and a way of using their surplus. The essential point is that some things are worth more to some people than others.

This has spawned huge global trades – just think of the silk trade, the spice trade, the slave trade (OK, better not). It also depends on the fact that some people are better at some things than others – also see next section. From this small but powerful principle, global trade has brought continued increases in GDP, along with:

3.         One man with a horse can plough maybe an acre a day (obviously depends on many factors). With a modern tractor, he can plough about 30 acres. That is an increase in productivity, and so one man can increase his GDP by a factor of 30. The percentage of the population needed to farm has shrunk from more than 50% to less than 1%. Productivity can increase without improvements in technology, by improved learning, training, specialisation and organisation. But technology is the ultimate driving force behind productivity improvement. (Steam power, combustion engine, electricity, computing, internet).

So, that is a very brief journey through the factors behind economic growth. The main point I am making here is that growth can occur without increase in population or use of resources.

Now it may be that we cannot continue to have increases in trade and productivity indefinitely, although that is a tricky question. Read Ray Kurzweil if you want to see why technology can continue to increase as far as we can see.

It has been said that ‘Technology has its own agenda’, which is to say that it will continue to increase whether we intend it to or not. Its hard to stop. Once the genie is out of the bottle, you can’t put it back (or Pandora’s box if you prefer). But it is simply incorrect to assume that lack of resources will cause economic growth to cease.

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