Wealth

There has been a lot of discussion about economic recovery and creation of wealth. The national economy is just too big to deal with. Seems like it's important to break it down to basics. As a non-economist, this is my attempt to get at the problem from the bottom up.

Working Definition

What is wealth? Without getting overly philosophical, we need a good working definition. Since this is an economic discussion, I'll propose a definition that's economic in nature:

Wealth is the degree to which an individual can satisfy their needs and desires through transactions with others.

This definition deliberately ignores many things that are of great value - the satisfaction of personal accomplishment, the joy of a loving relationship, and the beauty of nature to name but a few. These seem to me to lie outside the sphere of economic discussion, so I'm content to leave them for another essay.

Given a definition, there are some basic questions about the concept of wealth. Where does wealth come from? Is there a finite pool of wealth out there, so that someone can have more only as the result of someone else having less? Is it possible to create more wealth? If so, who creates it and how is that done?

If we can't answer these questions in a reasonably definitive way, then there's not much basis for any other discussion.

Wealth Creation

Let me suggest that there is in fact an ordinary everyday event that creates wealth. It's so simple and happens so often that we miss the beauty and elegance inherent in it:

Whenever two free and informed people voluntarily choose to exchange goods, services, or money, wealth has been created.

Think of it this way: Two people would only enter into such a transaction if they both benefitted. If they are both better off after the transaction, then wealth has been created.

Take a simple example: When you buy a loaf of bread, you've decided that you would rather have the bread than the money that you paid. You're better off after the transaction. The baker would rather have the money than the bread, so he's better off as well. All such transactions enrich both parties.

Money isn't wealth

It's easy to think of money as wealth, and jump to the conclusion that the person getting the money is the primary beneficiary. That is not the case - both parties benefit, or the transaction wouldn't happen. Money is simply a convenient way of keeping track of the relative value of goods and services. If you work for someone and they pay you $12 per hour, your purchase of a loaf of bread for $3 is the same as trading 15 minutes of your time to the baker. An interesting side effect is that each such transaction establishes a 'market price' that others can refer to.

Free Choice

In the definition of wealth creation above, the qualifiers are important - both parties must be free. Free in this case means that each is able to choose whether they will participate in the exchange. That means that they each have other options and the ability to choose between them. Both parties must be informed about the relevant details. The transaction must also be voluntary - free of coercion. Ideally, both parties would have many other choices so that they're choosing the best out of several possible alternatives.

The idea of free choice is critical and central. If you don't like the price of the bread, you're free to make a different offer, buy some other product, go somewhere else, make your own, or do without. You choose this transaction because it offers the best combination of price, quantity, quality, convenience, or whatever else matters to you personally at this moment.

On the other side of the transaction, the baker has many choices as well. He could make a variety of different products in different quantities. He could choose better ingredients, or try to minimize his costs. He could set his prices high, or lower the price to try and increase sales.

This is the essence of the free market. Individuals have maximum freedom to do whatever they want, and enter into agreements with others for mutual benefit. Endless energy goes into trying to make and find the products and services that provide the best value and the highest profit. Everyone benefits.

Personal Wealth

There are of course other ways that wealth is created. If you work to accomplish something that improves your own situation, then you are wealthier as a result. This is certainly a good thing, and the freedom to pursue this path to wealth creation is important. However, I suspect that this approach alone cannot address the economic problems of the day.

Wealth transfer

There are other types of possible transactions. You might voluntarily or involuntarily transfer goods, services, or money to someone else, thereby enriching the recipient. It MIGHT be the case that the value to the recipient is greater than the cost to you, in which case net wealth has increased. In the example of a voluntary transaction such as a gift, there is presumably some emotional or moral value accrued by you that more than offsets the costs.

In the case of involuntary transactions, it's still possible that net wealth could be increased if the value to the recipient is greater than the cost to the provider. However, the coercive nature of the transaction cast doubt on this premise, and it's arguable that the opposite is more likely true. If a thief steals a valuable antique and melts it down for the silver that's in it, wealth has been destroyed.

Investment

If the baker from our 'free choice' example above is highly motivated, he'll invest some of the money that he makes. He might buy equipment that will enable him to make more bread or better bread. If he's successful, he'll be able to enter into a larger number of mutually beneficial transactions. Remember that every transaction benefits both parties. As a result of his investment, he will become wealthier. So will every person that he does business with.

Of course, our friend the baker has competitors. If he buys equipment that will enable him to bake more bread each day, he'll likely have to lower the price a bit in order to sell it all. That has the effect of making each of his customers even wealthier - a unit of their time buys more bread than it did before. It has the side effect that his competitors will also have to either lower their prices or improve their product in some way. All of these are beneficial consequences. Effective investment improves productivity and increases the rate of wealth creation.

Profit

Profit is a pretty simple concept. It's the difference between the cost and selling price of a product or service. It's essentially a measurement of efficiency. The cost of producing a product or service is a measure of the resources consumed. The selling price is a measure of the value that people place on that product or service. If you can produce something with a lot of value while consuming very few resources, you can make a large profit. On the other hand, if you produce something of minimal value while consuming relatively more resources, you will find yourself with little or no profit.

Some people will argue that the seller sets the price, not the consumer. As long as there are choices, this isn't really true. Sellers will set a price based on a careful analysis of the market. If they set a price that's too high, they'll end up with a lot of unsold product. In that case, expect a big sale, or expect the product to show up in a discount outlet. Sellers in reality have very little control over price in a free market.

Of course, not all markets are free and customers don't always have reasonable choices. Because profits equate to personal wealth, everyone has a motive to interfere with free market forces. There must be safeguards to ensure that no one tampers with the essential elements of the free market.

Any business MUST be profitable, at least in the long run. If you aren't creating more value than the resources that you're consuming, you are a drain on society. An unprofitable business should simply evaporate, with its assets going to someone else who can hopefully make better use of them.

People should be 'profitable' too, in the same sense. Each person should be able over time to create more value than the resources that they consume.

Barriers To Wealth Creation

If it's that simple to create wealth, why don't we have more of it? When we're looking at people struggling with long term unemployment, why is it so hard to solve that problem? If unemployed people have unmet needs AND available time, what prevents them from providing goods and services to each other (and the rest of us)? How do we enable and encourage more people to participate in wealth creation?

Part of the problem is that we have over time created a plethora of barriers. Baking a loaf of bread creates value. When I sell it, it creates wealth. However, I can't simply bake a loaf of bread and sell it to you. First, I need to have a license to operate a commercial kitchen. Often, obtaining that license is made deliberately difficult, ostensibly to protect consumers. In reality, many such license requirements exist primarily to protect established entities from competition. If I get a license, there will still be pages of regulations that I must comply with. (Is the fire extinguisher mounted at the right height? Big fine if not.) I have to register with the State and the Federal governments. I have to record each transaction. I have to collect sales tax. I have to file a variety of monthly, quarterly, and annual reports. All of this activity takes time and money, and none of it creates any wealth.

If I manage to persevere and open my bakery, my costs will be much higher to pay for all the time and effort that it took to deal with the barriers. As a result, my prices will have to be higher and/or my profits lower. That means that each transaction creates less wealth for me and my customer. If the profit potential were minimal in the first place, it wouldn't make sense to even open at all.

The problem is much worse if I need to hire someone to help in my bakery. The number of regulations, filings, reports, and taxes increase exponentially. It's not simply a matter of offering someone a certain amount of money (or baked goods) in exchange for a certain amount of their time. I must also file tax paperwok, deduct Social Security and Medicare, pay worker's compensation insurance and unemployment insurance, calculate and withold state, federal, and possibly local income taxes, document and submit these and other payments to both state and federal government. I probably also have to provide and administer other benefits such as health insurance, dental insurance, life insurance, retirement benefits, and others. All of this takes time and money, and none of it creates wealth. It also requires a completely different skill set than baking bread. I'll almost certainly have to hire someone to administer all of the paperwork. That person costs more money, and doesn't result in any more bread being baked. In addition to the cost of collecting and administering various taxes, the taxes themselves are another expense.

Each expense reduces the chances that I can create a viable business. The expenses create a 'barrier to entry' - an initial investment that must be paid before I can generate any revenue. They also add to my costs, decreasing my profit margin and making the entire business less likely to succeed.

Another barrier is the risk of being sued. Any business is far more likely than a private citizen to be the target of a lawsuit. Even if the lawsuit is frivolous or without merit, it can involve enormous costs. The United States offers virtually no protection against damage from groundless lawsuits. This imposes additional costs and risks for every business.

Encouraging And Enabling Wealth Creation

If we want more wealth creation, we need to systematically dismantle the barriers to make it difficult to create wealth in the current system. At the same time, we need to ensure that systems are in place to maximize the chance that every transaction is undertaken by informed and willing participants with as many choices as possible.

Proposal 1: Review and reduce the regulatory burden.

Consider each and every regulation and license requirement. What direct and indirect costs does it create? Is it truly necessary? Is there a less intrusive way to accomplish the objective? Regardless of the original intent, does it create unintended consequences? Are there similar situations where no such regulation is in place?

The fundamental question is this: Is there a compelling need for the government to insert itself into the type of transaction that the business engages in?

Proposal 2: Stop using businesses to collect taxes.

If the government want to collect taxes from its citizens, let it do so directly. Let businesses concentrate on creating value for their customers, not being surrogate tax collectors.

Proposal 3: Tort reform and lawsuit risk reduction.

Protect businesses from the risk of unwarranted lawsuits. Adopting a British style 'loser pays' system would be one approach. Another approach might be to allow some form of independent review of products and practices that results in a 'stamp of immunity' that certifies that the products and practices in question have been found to be reasonable and prudent. Such a certification would then preclude any lawsuit attempting to claim otherwise. In some ways, UL certification of electrical devices provides some of that protection.

Proposal 4: Eliminate business taxes.

While this sounds a bit radical, it makes sense. Ultimately, businesses don't pay taxes anyway. Any tax imposed on a business results in some combination of secondary effects:

  1. Increased prices for customers
  2. Reduced wages for employees
  3. Reduced income for owners / shareholders

In all three cases, people end up paying the taxes. Eliminating business taxes would remove an enormous administrative overhead, as well as allowing many more marginal businesses to be profitable. It would also provide a large competitive advantage for companies that export products, or that compete against imported products.

If this is done, taxes on individuals would have to be increased to compensate for the government's lost revenue. However, people would be seeing some combination of increased income and lower prices which should more than compensate for the increased tax burden.

Proposal 5: Automatically incorporate every adult.

For vague historical reasons, much of our economy is based on a paternalistic model where the employer has all the power and the employee is essentially a dependent, and both parties are committed to a long term relationship which is difficult and painful to break. For the employee, all their economics eggs are in one basket - they only have a single 'customer' for their product. This results in a very poor bargaining position and a real loss of power and opportunity for independence.

There are other models. Both individuals and businesses routinely use contractors - electricians, plumbers, painters, and so on. In those cases, the business relationship is much more a mutual agreement between equals. Each contractor has many customers, and the loss of a customer is generally not catastrophic. Long-term relationships are possible (and common) but both parties are free to make changes to suit their needs. Perhaps most important, when you hire a contractor, you do not assume responsibility for their benefits or for collecting taxes from them. You are simply paying for the services that they are providing.

While I feel that people should be free to enter into any arrangement that suits them, I would suggest that many people would be better off if more jobs were handled using the contractor model than the employee model.

The need for rules

Lest anyone peruse the list above and suspect that I argue for anarchy, let me suggest that rules are necessary. Human self interest being what it is, there will always be some who seek to increase their own wealth at the expense of others. Rules are necessary to ensure the conditions specified above: Every transaction should be, to the maximum practical extent, the result of free informed voluntary choice.

Rules are certainly needed to ensure that people are free of coercion and that the transaction is truly voluntary.

Both parties must be informed. Rules are needed to discourage participants from hiding information or providing false or misleading information.

In order for choice to take place, it's vital that the participants both have other options. Rules may be necessary to ensure that neither party takes actions that might limit the options of the other party. Establishing a de facto monopoly for a good or service might be an example of such an action. Using the government to enforce licensing regulations intended to discourage competitors might be another.

There's at least one more situation where rules may be necessary. There are situations where someone could enrich themselves by taking actions which cause harm to others. It appears that there must be some limits imposed. Almost any action could be construed to cause some amount of harm, which may or may not need to be taken into account. For instance, farms produce manure. In a rural setting, this should not be cause to prohibit farming. However, if I want to set up a junkyard alongside the village green, it's fair to say that my actions cause significant damage to others and should be subject to some constraints.