Let's run a thought experiment in the favorite setting of the economists: two guys stuck on an (otherwise) uninhabited island.  Suppose that they spend their time gathering an equal amount of two kinds of fruits; at least, until they discover that one of them can be gathered much more easily by, let's say, prodding it off the tree with a long stick.  How does their production-and-consumption of the fruits change?  Where's the new equilibrium?

That depends on quite a lot of things.  If they were on the verge of starving to death, probably they will spend much more of their time gathering this fruit, and much less of the other.  If they were well-fed and had leisure time on their hands, their eating habits determined by taste more than anything else, they will gather about the same amount of each fruit as before.  If this fruit was already easier to gather than the other, but less tasty, then—by becoming easier to harvest—they will gather less of it.

And then what happens, if the two guys have different tastes?  If they are not equally able, but have absolute and/or comparative advantages?  What if the value they put on an additional fruit depends on both how much they have of that fruit, and on how much they have of the other fruit?

I think you can tell, there are a whole lot of quite independent variables here.  For N people and K possible "fruits", there are at least N*(K+1) dimensions to the whole system, possibly as many as N*(2K+1).  Why the +1, you ask?  Leisure time!

As you can imagine, this quickly becomes computationally intractable.  Determining the single equilibrium point the system will take on—is there even any guarantee that there is only one possible equilibrium?—is, for all intents and purposes, impossible.

Building the economy, feature by feature

But we can go back to a clean slate and have a few simplifying assumptions.

The above statements are known as Say's law.  It can be made shorter, though less correct, by saying that any production creates an equal demand for other goods.  Personally, I prefer to say something different, by stating the blindingly obvious: a society can only consume as much as it produces, whether they trade with the outside world or not.


But I'm getting ahead of myself.  Let's return to the guys on the island.  Even if they started out with the same skills, there can be a reason for them to do different things and trade the results.  If one spends more time ...say, fishing, he'll become better at it.  "Practice makes perfect." 

However, specialization is limited by the number of people on the island.  If they want only so many huts, there is no need for a specialized hutbuilder.  Consequently, there will be nobody who can build huts particularly well—but that's not a huge problem.  After all, the reason is that they don't spend too much time building huts in the first place.


As the number of people on the island increases, more and more can specialize in something.  Unfortunately, this makes it increasingly common that one want something from the other, but the other wants something other than the first has to offer.  Economists call this the "double coincidence of wants" problem.

The most common solution is to elevate a few commodities by conferring high moneyness to them.  If everybody knows that others will accept them in return for their goods, they will accept it for theirs.


For the next step, let's add a second island.  And to make it very easy to follow, let's have only a single guy paddling a canoe back and forth.

First, suppose that on the two islands, the residents have chosen two different commodities as money.  Thus it is entirely pointless for our trader to take either sort of money with him, because when he gets to the other island, nobody will accept it from him.  He will only take goods with him, and though he may sell them for the local money, he will spend that to buy other goods to take back.  For the sake of simplicity, we can say he traded goods for goods.

Where's his business, then?  Inside the fact that the two islands are different, even if by specialization.  One is better suited to make one thing—bananas—and thus the people are willing to give more bananas for each coconut than the people on the other island.

If one island has nothing to give in return for the goods from the other island, then no trade happens.  For example, if no produce from one island (except its money) fits into the canoe.

"Price-money flow"

Now let's ask what happens if the two islands use the same commodity as money?  Even if nothing else, the money-commodity would fit.  And because it is accepted as valuable on the other island, its residents would take it as payment and give goods in return.

However, this cannot go on forever.  In the limit case, the first island simply runs out of the commodity.  But even before that, there would be fewer and fewer pieces of it to go around and serve as money, thus individual pieces would be worth more to the residents.  Eventually, they would not be willing to pay as many pieces of it as the other island's residents would demand for their goods.

And on the other island, more and more pieces of money would be in circulation.  Divided between the unchanged number of people, and the unchanged production of the people, this would make pieces of money easier to come by, and each individual piece less meaningful.  As such, any goods would be exchanged for more pieces of money, and this fully applies to the price the trader has to ask from the first island.

The first island experienced some deflation while the other experienced some inflation.  While this is a really nice theoretical result, in real life this tends not to happen.  Because real life has several features we haven't yet introduced (most importantly, capital investment and securities), and because nearly anything can be transported between countries (though perhaps expensively), there is pretty much never a case of not knowing what to import in exchange for the money gained through export.  "Dutch disease" is just stupid monetary policy.  In particular, the central bank can always buy forex and lend it out abroad.  Or even more drastically, it could adopt the current forex rate as a currency board, and subsequently crawl the peg downwards.

Returning the scales

We can ask what happens if the trader enlarges his canoe, so that he can now take some goods from the first island to the second?  Now, on the first island those goods only take a few pieces of money, while on the second, they are paid for with many.  This returns some money to the first island—which also opens the door for again importing goods from the second.

In the end, the result is much the same as if the islands had different monies.  Goods are paid for with goods.  If the same commodity is accepted as money on both islands, that can slosh around a bit and act as a buffer.  But in the end, real goods and services are what matter.

Capital-to-labor ratio

Let's leave money alone for some time now, so that we won't be confused by its more complicated tricks.  Concentrate on the real economy.  Let's start out with 20 artisans who weave cloth by hand.  They are sort of poor, but not intolerably so.

Now, let's say that two of them somehow get a power loom each.  Each loom only needs one man to operate it, but weaves as much cloth as ten artisans.  Obviously, the others cannot compete with that, and go out of business.  Thus, now we have two entrepreneurs (who own the looms), two men operating the looms, and 16 who are unemployed, or get jobs ...sweeping the floor, or something.  The term for the latter is underemployed.

The overall amount of wealth (in this case, cloth) created is the same or more.  After all, those 16 un(der)employed now perform services that didn't exist before.  However, those 16 are desperately poor.  Furthermore, the two guys operating the looms are not much better off.  There are eight people standing in line behind them, ready to take their job in an eyeblink.  Thus, their wage is low and the working conditions awful.  As such, most of the wealth created goes to the two capitalists, i.e. the two men who own the looms.

But now, imagine that there were not two looms, but 18.  First off, everyone would have a job.  Second, the output of society would be much more than before; now there is nine times as much cloth to trade.

Third—and this is the most important—wages would go up.  If anyone didn't work, a valuable loom would be left just standing there, not producing anything.  Thus, its owner would pay quite a lot for someone to come and operate it.

Indeed, suppose that there were one more loom than people to operate them.  Then its owner would be prepared to pay almost its entire production to the man working it, because he is still better off that way, than with the loom just standing in the corner, and not producing anything.

You can look at it from a different angle, too.  If capital is scarce (relative to labor and technology), then it is expensive—the returns to capital, the interest rate are high.  If capital is plentiful, then it is comparatively cheap.  This obviously means that in the first case, producing capital is a good deal; in the latter case, not so much.

As such, if there is as much capital as society can use at the given level of technology, then it doesn't really matter who owns it.  Wages will be high, and working conditions acceptable.  Furthermore, if somebody wanted to hire someone to sweep the floor, they would have to pay about as much as that person could get by operating a loom.  As such, if there is an abundance of capital, it is good even for those who have low-productivity (not capital-intensive) jobs.


But where does the capital come from, and why?  Let's look into the entrepreneur's books.

Let's say that the difference in value between the input—the raw materials used—and the output product is given.  This value added is then distributed between a few different people in some proportion.  One part goes to the worker, as his wage, also known as return to labor.  Another part goes to the capitalist, as his profit, known as return to capital.  The third part goes to the government, as taxes.

We saw that when there was only a little capital to a lot of labor, the returns to labor was low, while the return to capital was high.  When there was more capital than labor, the opposite happened.  And in either case, some of the value added went to taxes.

Now, entrepreneurs are not complete idiots.  If they calculate that, after paying a sufficiently high wage to attract a worker, and paying taxes, they would be left with nothing for themselves, they aren't going to invest.  Indeed, if they know of a better use of their money, they aren't going to invest in anything that promises less profit.

This is (half) the why question.  Let's look at the where does it come from part.

Capital investment (power looms in our example), like everything else, need to be created before it can be used.  It isn't impossible that the capitalists simply built it themselves in their spare time, but it's much more common that they bought it from someone else.  Bought, with money from where?


Either from money that they saved, or from money they borrowed.  There aren't that many other options.  These two are known as equity and debt, respectively.  Equity is pretty straightforward.  But, where does the money behind debt come from?  From somebody else, who has money, and is willing to lend it.

As it turns out, there are lots of people who have some savings, but they don't have enough to start a business all on their own.  And/or they don't feel up to the task, are occupied with other concerns, etc.  But they want their money to not just be stuffed into the mattress, so to speak, but—if possible—produce some income for them.

And at the same time, lots of budding entrepreneurs (and even large companies) who have good ideas, but don't have the money now to do them.  However, they feel confident that they will be able to pay it back, from profits.  In other words, to use some of the returns to capital (from the future) to pay for the stuff up front.

The point of this excursion was that capital investment comes from savings.  It doesn't matter if it's the capitalist's own time and effort, their saved money, or someone else's saved money.  It's pretty obvious in hindsight: society as a whole produces stuff that they don't immediately consume.  (And they don't just hoard it, but they put it to use.)

The above description is correct enough for the purpose of understanding the real economy, but is somewhat simplified.  It essentially says that people with money to invest seek out a company and buy bonds or shares.  Once this used to be the case, but is long since obsolete.  A more up-to-date description about finance can be read here.

Capitaly, part 2

That's where capital comes from.  And now we can also complete the answer to why:  capital is invested where it will produce the highest returns to capital.

Which is good news (and bad news).  Remember that returns to capital is what remains from the value added after wages and taxes are paid.  Thus capital will flow to wherever it can create the most value... and to wherever wages and taxes are lowest.

This shouldn't be too surprising.  If the capital-to-labor ratio is low, returns to capital are high, and thus everyone will be falling over each other to invest there.  If it is high, exactly the opposite happens.  But if someone comes up with an idea that is even more productive than the power loom, they will be able to pay as much (or more) for someone to work for them, and still have a nice profit.  Thus both workers and capital investment follow the new idea, while the now uncompetitive power loom business shrinks.

Complications due to money

How does seigniorage fit into this?  It is widely believed that the new money is created out of nowhere, yet it is used to buy physical capital.  This is how central banks like to support their policies, too.  Lower the interest rate, they say, because a capital-rich economy has low interest rates.  And faking the result by a top-down decision is the same thing, right?

This belief is false.  The new money created is backed by the IOU of the borrower, or whatever other asset was provided for it.  And after it is spent buying physical capital, the new holder of the money will either keep it, or exchange it for some of the assets backing it.  As such, whoever has it is contributing it as savings to the loan.

Also, the returns to capital, and thus the "natural" interest rate do not change just because somebody makes monetary policy.  What changes is the level of inflation.

Inflation and investments

If inflation were perfectly predictable, it would have little effect other than shifting the interest rate.  However, it is not predictable, and that has several consequences.  An unforeseen inflation hurts those who have saved, and thus have money, deposits or bonds.  At the same time, those who owe money (have debt) are benefited.  An unforeseen deflation has the opposite effect.

If it is known that inflation is unpredictable, potential savers and debtors alike want to ensure they won't be unduly harmed by it, whichever way it moves.  Thus they are less willing to lend or promise to pay, unless a (respectively) higher or lower interest rate is written into the contract.  Effectively, unstable inflation can be treated as a forex risk between money now and money later.  As such, it hiders the process of saving and investment.  That is a drag on the economy that should be thrown away.

Price stickiness

Unfortunately from the theoretical point of view, the price of many things does not follow inflation immediately.  All sorts of contracts, such as wages, are set a long time into the future.  Even the prices of simple goods and services, such as a meal at a cafeteria, tend to stay constant for months at a time.  At the same time, there are several things whose future price speculators try to guess. 

Imagine what would happen if your country's currency suddenly fell to one-tenth of its value.  Vehicles of speculation such as foreign currencies, gems and gold would adjust their price almost instantly.  So would shares, but their case is a much more complicated.  On the one hand, bonds wouldn't move, thus their part of the balance sheet would shrink, leaving shares to appreciate in real terms.  On the other, due to historical cost accounting, the business would pay higher real value to taxes, decreasing the value of shares.

Goods that are mostly exported or imported would quickly move after them.  They now cost ten times as many units of money abroad, with which domestic buyers must compete.  The change would not be instantaneous, but it would happen in a day or so.  After all, quick businessmen could just buy up a lot of the easy-to-move goods and sell them abroad in a matter of hours, given a sufficiently drastic revaluation.

Goods that are largely immobile or are simply not traded much (such as real estate), as well as services that cannot be moved (such as cleaning) would be the slowest to respond.  Only because the residents have more units of money to spend, because they earned more through dealing with other goods and services, are they willing to pay more for real estate, driving its price up with a long lag.

Wages are in a somewhat similar situation.  Employers abroad are willing to pay a wage worth ten times as many units of money, but moving to a workplace abroad is difficult and even slow.  Exporters can afford to pay ten times as many units, but until they have to, why not keep the difference as profit instead?  Services that can be moved (call center) compete with those abroad, but changing careers is even more difficult than moving abroad.

And, above all, fixed-term employment contracts have a duration measured in months or even years.  Even though many would be broken in an extreme case of a tenfold devaluation, they mostly expire without renegotiation in the usual case of gradual inflation.

As a consequence, inflation rewards exporting companies and foreign tourists, while punishing those consuming imported goods or traveling abroad.  It is claimed that—because the price of goods rebounds faster than wages do—it decreases real wages and consequently increases employment.  However, that effect is rather slight and ephemeral, given that an increase in employment naturally causes an increase in real wages.


I mentioned that the value added gets divided between labor (wages), capital (profit) and taxes.  And that capital goes wherever it finds the highest returns to itself.  These are important because taxes greatly influence the economy.

For an extreme example, if the government placed a 100% tax on wages, nobody would want to work.  Not legally, at least.  Or at the very least, they would get tricky about it, and would exploit loopholes.  People would form tiny enterprises with no assets, take jobs as a contract between their company and the employer, and then pay the "wage" as a dividend to themselves, the owner.  Technically not a wage, thus no tax.

There are any number of similar reductio ad absurdum examples, where something gets hit with a 100% tax, and thus nobody has any incentive to do it legally.  But the tax need not be this steep to have a significant effect on the economy.

Remember the great importance of the capital-to-labor ratio.  If the government places taxes in the way of capital accumulation, or puts a burden on income from capital—"make the rich pay!"—, what do you expect to happen?  What you get is less capital investment, thus a lower quality of life for everyone—except for the capitalists, perhaps.  Although they have to pay more of the returns on their capital to taxes, there are more returns to begin with, because capital is scarcer.

Similarly, if there are different rates of taxes on different industries—or in different countries—then the returns to capital will shift.  The industry or country burdened with high taxes will not see investment on the same scale as others, because (assuming similar costs for labor), there is simply less returns to capital left.

This lopsided investment of capital might, then (under approppriate conditions) shift wages sufficiently to cause significant flows of labor.  The industry declines, and is replaced by imports, because the price of its product goes up.  The country withers as its population leaves for more prosperous neighbors.

Which neighbors then become increasingly xenophobic, since the newcomers increase the labor pool and dilute the capital-to-labor ratio downwards.

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