How the economy works



This article describes seven mental models that drive our economy. These are meant to give the reader a thought process to evaluate and form an outlook for the future. Other factors are, of course, present and we don't pretend to capture everything that drives how an economy works. But these are the most influential underlying systems at play that we believe explain the lion's share of how prices are determined, how value is created, what causes recessions, and the conditions that promote innovation.


We discuss each in turn.


  1. Supply and Demand

  2. Creative Destruction

  3. Diversity and Complexity

  4. Capital Cycle

  5. Short-Term Debt Cycle

  6. Long-Term Debt Cycle

  7. Stability Cycle



1. Supply and Demand


In a free market with a sufficient number of buyers and sellers...prices are determined by supply and demand. While many may be familiar with the concept, the importance is difficult to overstate and implications for markets are often overlooked. Before getting into a few controversial examples lets cover the basics.


Purely free markets allow for anyone to buy and sell at whatever price they wish. Suppliers make goods and services. Consumers buy them. At lower prices consumers will generally demand more of something. In contrast, at lower prices suppliers are willing to make less. This is illustrated by the supply and demand curves below...and the quantity at which supply equals demand is the market clearing price.

The simplicity and power of this model is driven by the fact that most everyone is motivated by make and save money. This is why market prices are so important, and provide perhaps more insight than just about any other data one can get on a market or economy...compared to other measures such as surveys or estimates of economic growth.


Now for three controversial examples...the Drug War, Minimum Wage Laws, and Free Education. These are purposefully provocative in order to make the point more clear and memorable.


Example #1: Drug War Supply Restrictions


Illegal drugs are a big problem in the United States. For decades we have waged a "War on Drugs" that has led to nothing but gang violence, high drug prices, and unnecessary death. There will always be people that demand addictive drugs such as Cocaine. So what happens when we make these drugs illegal?


Making something illegal essentially makes it more expensive to produce because of the added cost of hiding production, distribution, and risks of getting caught. But history has shown these costs to be insufficient in stopping production. Why? Because demand for addictive and powerful drugs like cocaine is "Inelastic".


Inelastic demand means that consumers are not very price sensitive so when we impose additional costs on suppliers by making a drug illegal all we really accomplish is pushing the market clearing price higher. This is illustrated by moving from the right chart below. Yes, the quantity supplied is reduced, but this is a small effect compared to the much higher prices that are required to make drug manufacturing and distribution a viable business model.


Those that support the War on Drugs are by and large not willing to accept the power of supply and demand. The cost is largely carried by those who are addicted to these drugs. Drug addicts are disproportionately lower income and less educated people. By making drugs illegally we completely failed in preventing drug addiction, but we did accomplishing making drug addicts pay more for their drugs, stigmatized addiction making it harder to seek help, and created a lot of illegal businesses that don't pay taxes and kill a lot of people in the process of supplying a business that will always exist.


Example #2: Minimum Wage Laws


A minimum wage is a price floor. Price floors essentially force those that supply and demand a good or service to accept a price that is higher than they would have in a free market. In the labor market, those that work are the suppliers of labor, and businesses and the consumers who demand labor. So imposing an effective price floor requires employers to pay more than they would have in a free market.


However, minimum wage laws do not require businesses to hire as many people. As a result, a simple supply/demand model suggests that while wages must rise to a higher than market clearing price, the number of people that get paid this price would fall. Examples of these would be employed people who now can't get work are often entry level employees like new graduates from high school and college who lack the experience to demand higher wages.


Attempts to help improve wages are generally well meaning, but direct approaches like minimum wage laws have probably led to higher unemployment. This has led some countries like France to impose additional restrictions on business to make it harder to fire people. But this only makes businesses that much more reluctant to hire. These effects are evident from the chronically high level of unemployment in France compared to the USA.

Source: https://fred.stlouisfed.org/graph/?g=y2yU


An approach to improving wages that works with, rather than against supply/demand would be to improve the value of labor. We could do this by improving the quality and access to education. But here again we need to be aware of just how various policies are impacting the market.


Example #3: Free College Education


One well meaning attempt to improve wages has been a proposal to make college free. This sounds like a good idea on the surface. But what impact would this have on the market for college education? There are a few...

  • Many students would pursue degrees regardless of their ability to complete them.

  • Many unqualified teachers would get highered to satisfy the large influx of demand because with the government is paying the bill.

  • Many would receive degrees that do not add much value to society because they didn't have to pay for them.

Making anything free essentially removes the free market mechanism for determining its value. Education happens to have many positive externalities, meaning that society benefits when more people get educated. This supports the idea of making college more affordable beyond the free market clearing price. But making anything free prevents supply/demand from doing its work of helping this process deliver an efficient outcome for society.


Reasonable people can disagree with these controversial examples. Markets are complicated. But the power of supply and demand in driving our economy is hard to overstate. The reason comes down to incentives...and if you know how markets are incentivized you can often predict the outcome.




2. Creative Destruction


The concept of “Creative Destruction” as a central driver of capitalism was first brought to popularity by economist Joseph Schumpeter. Creative Destruction describes how innovation leads to the creation of new goods, services and processes that lead to the obsolescence of previous methods. It also includes continuous improvement of current goods and processes that deliver better outputs and better prices. These changes result from academic research, continuous process improvement and new options for consumers as entrepreneurs disrupt existing markets.


Economies that allow for failure are more powerful. The reason is that trying to save and protect the old and dying business models of the past necessarily prevents resources from being directed toward new innovation.


One reason the United States is the home to most of the world's most powerful and successful companies is because we have not generally been very protective of failures. One way to measure this is tariffs. Aside from a hopefully brief attempt by Trump to screw this up...the USA has one of the are the lowest tariff rates in the world. In contrast, the EU has a nearly 30% higher tariff rate. China is nearly triple the USA. One reason why China's GDP growth has been so fast and why it is hope to many more innovative and disruptive businesses than India is protectionism. India has one of the highest tariff rates in the world.



Another way to observe the degree to which a country embraces creative destruction is how long they allow companies to avoid failed companies that are behind on loan payments to go bankrupt. During the Financial Crisis many loans became delinquent. The United States is generally quick to identify a loan that is in default...sending the company into bankruptcy proceedings. Other countries like France (it's easy to pick on France) let delinquencies linger at high rates for nearly a decade.


Creative destruction is painful...and countries that accept that pain are better positioned to reap the gains. Unfortunately the USA might be on a path toward more protectionism. Nearly 20% of corporations in the USA now pay more in debt interest then they receive in income. This is a common way of measuring the percent of corporations that are called "Zombie's" because they are effectively dead but continue to exist by refinancing and going into more debt. Lower interest rates over time have allowed this trend to persist. How much longer we can go will depend to a large degree on whether the USA is willing to continue accepting the pain and benefits of creative destruction.





Creative destruction is painful...and countries that accept that pain are better positioned to reap the gains. Unfortunately the USA might be on a path toward more protectionism. Nearly 20% of corporations in the USA now pay more in debt interest then they receive in income. This is a common way of measuring the percent of corporations that are called "Zombie's" because they are effectively dead but continue to exist by refinancing and going into more debt. Lower interest rates over time have allowed this trend to persist. How much longer we can go will depend to a large degree on whether the USA is willing to cont


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More to come...