#106 Understanding Capitalism: How it works and its impact on the economy
04.01.2023
People are losing jobs. The markets are crashing. Layoffs are happening every day while the companies are turning into ‘come pennies’. This economic contraction, or commonly referred to as recession, is likely a function of a modern capitalistic economy. Have you ever wondered how capitalism works? What exactly is capitalism? I thought about it last week and let me share my findings with you.
There’s a famous tale of Charles Dickens called the mortality tale, where the penny-pinching Ebenezer Scrooge accumulates and saves wealth for his entire life, collecting mountains of interest but spending only the bare minimum. And when death confronts him, he realizes that no one mourns his death and the poor couple indebted to him is actually happy that he is dying. He sees the light, opens his coffers and begins to spend, spend, spend, enjoying his life for the first time by spreading happiness to everyone around him.
Do you think the habits of Scrooge align with the concept of capitalism? Well, capitalism is the complete opposite of it. If we all become like Scrooge, the money misers, no one would spend anything and this will lead to an economic stand still. Yes, the goal of capitalism is to make you earn more, but at the cost of making you spend more. In other words, the ultimate goal of capitalism is to make you spend more. Every action, every scheme is set to make us spend more and make us completely opposite to Scrooge. Let’s understand the way we understand well, by using an example.
Consider for example, you have a property in the middle of a busy market and you are willing to sell it. I spend my money to buy that property from you, for say $40,000. This increases your income (+$40,000). This exchange of money for goods and services is called transactions and the goal of capitalism is to increase the number of transactions (can you now relate why UPI transactions are free?). With this extra cash in hand, you are in a better position to spend more money, and with that spent money, you will increase someone else’s income and they will be in a better position to spend and so on and so on. This self-reinforcing pattern leads to what we call an economic growth. More spending means more earning, which means more spending, and which in turn means a thriving economy.
However, I cannot spend money until I have some income. So let’s say that instead of keeping that property empty, I decide to turn it into a restaurant and since it is in the middle of a busy market, my business takes off. This will not only increase my income but also increase the income of a number of other people who will be employed in my business. However, after a few months when my income reaches the ceiling value, problems begin to arise. Even though I have a regular number of customers every month, my income is limited by the space available. And with the little income I have, it looks like it’s gonna be a while before I can afford to buy another property to expand my business.
Now… since my spending is someone else’s income, and their spending is someone else’s income, and so on… my lack of spending is therefore breaking this self-reinforcing pattern and in fact hurting the economy. The only way I can increase my income is by increasing the economy's productivity. But it is a slow process and capitalism wants to increase my spending power now and not in the future.
This brings us to the voodoo concept of borrowing.
Borrowing is the dark magic shortcut to obtain things you want but cannot afford to have right now. Suppose I borrow $40,000 dollars today (from a bank) and churn up another restaurant chain. This in turn increases my income and my spending in buying the property increases someone else’s income. Say they further borrow $10,000 from the bank and spend it to buy a car. This increases the spending power of the car seller and so on and so on. Do you see? Do you see how borrowing increased the spending power in the hands of people again?
That’s in fact the beauty of capitalism: I don’t have to solely depend upon my ‘productivity’ and ‘hard work’ to grow my income. I can take a shortcut. In fact, I’m encouraged by the economy to take this shortcut.
But there’s a little caveat again in borrowing. I am borrowing today only because I have confidence that in the future I will be earning enough to repay the debt and the interest on it smoothly. Interestingly, this means that there would be a time in future when I would use my income to focus more on repaying my debt instead of spending. This is true for an individual as well as an economy. Since my spending is another person’s income, economic growth would most probably slow down sometime in the future. But we’ll cross that bridge when we get to it. For now, let’s borrow some more!
When we push it, borrowing — although it creates more spending — allows income to rise faster than economic productivity, and this isn’t good for obvious reasons. Suppose instead of using those $40,000 to buy a new property, I instead spend it on improving the interior of my first restaurant. All this stuff that I bought with the borrowed money doesn't generate any income for me. Unlike my business, they are dead assets or ‘liabilities’. Had I put a major chunk of that money into my business, I could have grown my income, paid back my debts, and probably improved my living standards with the income from my business. But… instead of slow money (income) I chose fast money (debt) to buy liabilities, and soon it’s gonna come back to bite me in the ass.
As I am primarily concerned with borrowing and spending, rather than expanding my business, it could cause a decline in economic productivity. However, the intriguing aspect is that my spending becomes someone else's income, so everyone still has significant spending power. The issue arises because the decrease in economic productivity means there are limited options for utilizing all the available money, resulting in a classic problem of high demand but limited supply.
Then how do we handle such a situation? Let’s leave it for next Saturday..
Until then, have a great time :)
Cheers!
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