Creating a durable economy

Discussing the causes of the Industrial Revolution in Britain in the 19th century in the book “A Farewell to Alms — A Brief History of the World” the author, Gregory Clark quotes Douglas North:

Institutions form the incentive structure of a society, and the political and economic institutions, in consequence, are the underlying determinants of economic performance.

Institutions are some of the most important factors for accounting for not only the Industrial Revolution but also much of the way an economy works. In fact, I am persuaded that right institutions are possibly the only important forces that exalt a country economically.

Suppose that, for any reasons, the amount of goods and services exchanged between people in a country increases per unit of time. If the medium of exchange is the currency of that country, people will demand more money. The monetary authority, which is usually the central bank, will respond by either increasing or fixing the money supply. If the money supply is fixed, then the value of the money, i.e. purchasing power of the currency, will increase. If the supply of money increases in proportion to price levels, then the quantity of money in the economy is increasing as a result of a growth in goods and services. Changes in money supply affect neither the rate of exchange nor the amount of goods and services exchanged. An excess money supply, however, leads to higher price levels and a lower value of money. This is called inflation.

There are at least three possible explanations for an increase in the amount of goods and services exchanged per unit of time. First is that, people have more money to spend. Secondly, the money is distributed to more people. Third is, people have more money to spend and that money is distributed to more people. Because the third one can be explained using the first two reasons, the following discussion focuses on the first two reasons.

If people have more money to spend, this money will come from the fact that they are receiving higher gains from the economic activities in which they engage. If the supply of money is fixed, the higher gains from their economic activities is a reflection of a higher value of the money, i.e. a higher purchasing power of the currency. An increase in the value of money which is equivalent to a decrease in price levels will be reflected in an increase in the amount of the goods and services of the country’s economy. If the money is distributed to more people, it means that more people are finding jobs — either through self-employment or through employment in various sectors, private or government. Likewise, if supply of money is constant, it must be that the value of money increases in order to explain the increase in the amount of goods and services that people exchange. Otherwise there is an increase in the quantity of money in the economy that is proportional with the price levels. In all these cases the economy will be said to grow.

Why and where do people exchange goods and services? According to Adam Smith, the author of ‘The Wealth of Nations,’ two parties will exchange goods and services only if they both will benefit from such an exchange. Goods and services are exchanged in the market.

Up to this point, at least two things are worth emphasizing. An increase in the number of goods and services exchanged can only be increased if people have more money to spend, or if more people have money to spend. This therefore entails that people must — through employment — engage in economic activities that give rise to returns that increase over time. Crucial in this process is the market where the exchange takes place. The result will be a growing economy.

In general, an economy can be considered as formed of the private and the government sector. The private sector may not create enough jobs that may lead to full employment. Thus the government sector must come in to fill the gap. This thought was put forth by John Maynard Keynes, the author of ‘The General Theory.’

How does the government balance the wheel? By spending. What would the result be? Suppose the government spends 100 dollars and suppose also that the receivers of the 100 dollars spend a proportion of it and save the other proportion. Then the proportion saved will be received by others who will save a proportion of the money they receive and spend the rest. And so on. On the aggregate, the economy may gain 300 dollars additional income. This is what is called the multiplier effect. Where does the government get its 100 dollars from? On what sectors should the government spend? So asks Milton Friedman, the author of ‘Free to Choose‘ and ‘A Monetary History of the United States, 1867-1960,’ who maintains that the private sector is sufficient to provide full employment when the size of the government is small and provided that free-markets prevail. The answers to Friedman’s questions are not very easy to give.

J. Bradford DeLong compares Friedman and Keynes: “Friedman and Keynes both agreed […] that the private economy on its own might well be subject to unbearable instability ­and that strategic, powerful, but limited economic intervention by the government was necessary to maintain stability. But, while for Keynes, the key was to keep the sum of government spending and private investment stable, for Friedman the key was to keep the money supply — the amount of purchasing power in readily spendable form in the hands of businesses and households– stable.”

To this end we can summarize the following. People exchange goods and services in the market. If the exchange is “voluntary”, two people will participate in the market only if they both will benefit. The number of goods and services exchanged increases because the economy is growing. The economy is growing because either more people are finding jobs or people are receiving higher gains from the economic activities they engage in. Or both. The market can lead to desirable results when uninterrupted but enhanced, by the governement, to function better. Keynes and Friedman complement each other in providing us with the most fundamental building blocks for understanding how an economy works, and how to make the markets help organize an economy to deliver efficient outcomes.

If an economy can create and ensure an efficient functioning market and provide incentives and capabilities for people to participate in the market, more goods and services will be exchanged. The economy will see greater growth as a result. In a political setting such as a country, it’s the prevailing political and economic conditions that foster for a well-functioning market. What can lead to a well-functioning market? If the government can create institutions that can help the market function better and hence give incentives for people to participate uninturrupted or forced, the economy will grow and produce desirable outcomes. If these institutions are so well engineered that they act like ‘frameworks’ within which the markets can timelessly function the growing economy will be durable. These institutions are such as the educational institutions that will help create more efficient labor, and the judicial institutions that can ensure that no one can robe me while I voluntarily pursue my interests in the market. Indeed, as Amartya Sen, author of ‘The Idea of Justice‘ and ‘Development and Freedom,’ writes, “[The] institutions and rules are […] very important in influencing what happens, and they are part and parcel of the actual world as well.”

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