Last week I used a model of a very simple economy – cash only, no innovation, nothing ever changing – so that we could see in isolation what happens when one person disrupts the equilibrium by saving. This week, I’m going to add productivity to this model.
So I want you to imagine a country that is just like Orderlyland, except that people are constantly innovating, finding new, more efficient ways to make things, and inventing new products – in other words, productivity is always on the increase. Let’s call it Dynamicland – like Orderlyland, only dynamic.
How do these increases in productivity come about – this can’t just happen by magic. New productivity means research and development, and then new processes, new machines, new factories, and all that needs to be paid for. We call this capital investment.
In economics, investment has a very specific meaning, covering two things. First, it means the purchase of goods that enable production to happen, but don’t get used up in the production process itself. That’s a much simpler concept than it sounds. To make something you need the raw materials that go into it, but also the tools and machines to make it with, and the buildings to make it in. Those machines and buildings are investment goods – once you’ve bought them, you expect them to last a long time and be used over and over again in the production of other goods. They’re called fixed capital. Increases in productivity will generally require fixed capital investment.
The second aspect of investment is an increase in the stock of unsold or unfinished goods. At the start of the year, any firm will have an inventory of stock waiting to be sold, and stock that is only part way through the production process. We’ve already come across this form of investment in Orderlyland, when Bob’s saving caused an economic slowdown, and some businesses end up with an increase in unsold inventory. In economic terms, that increase is counted as a form of investment.
I try to only use the term investment in its narrow, economic definition. If I use it in its broader, everday sense, I will put it in “”. We talk about “investing” in the stock market, but this is not investing in the economic sense, it’s actually a way of saving – buying shares only leads to investment if the company takes the proceeds from selling stock and spends it on new fixed capital or increasing inventory (we will add this component to our engine in due course).
So coming back to Dynamicland, all this innovation requires fixed capital investment. In Orderlyland, businesses cover their investment needs by saving. Say a firm has an expensive machine used in producing its goods, that lasts 20 years. Each month they set aside 1/240th of the replacement cost of that machine, and after 20 years they’ve saved enough to replace the machine. (In fact, for the Orderlyland model to work, the total saving of the business sector each month has to exactly equal the expenditure on fixed capital investment by the business sector – you don’t need to know that, I’m just mentioning it in case it’s irritating any economists or mathematicians reading this.)
In Dynamicland, business are not just replacing machines as they wear out, they need new ones to do the job more efficiently or to make something they’ve never made before. They cannot simply fund this out of saving, because not only do they not want to wait years to save up to buy the machine, it is likely that they simply cannot make enough profit to save until they have that machine to manufacture the goods to make the profits.
In these instances, what the business needs is credit. Rather than save up to buy the machine, they buy the machine on credit, and make repayments on that credit each month. Now there will be a cost to accessing this credit, so the business will end up paying more for the machine (interest payments, for example) – but this is more than outweighed by the benefit of having the machine now. Rather than saving up for years to buy the machine, all the while waiting until the glorious day they can swing into production of their new good, with credit that day comes now – and a higher monthly payment or longer period to pay it off is a small price to pay.
So we started out just adding productivity to our model, and immediately we discovered that we need to add in investment. And now we’ve discovered that to have investment in our model we need to add credit, which we will examine in more detail next week.