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2 What is wealth?

Basic economics; GDP explained

To understand what has really gone wrong with the economies of the developed world, it might help if we give some thought to the concept of wealth. Riches, abundance, prosperity, even just a general feeling of well-being or happiness: all these can be thought of as wealth.

By some measures (for example, the World Bank’s 2006 report, Where is the Wealth of Nations?) wealth includes ‘intangible capital’, as well as the stuff we might normally think of as wealth, such as property and money. By ‘intangible capital’ the World Bank means human potential, as defined by the quality of education and the political and social institutions of the nation in question.

These are difficult things to measure of course, so economists and governments calculate the wealth of nations in terms of Gross Domestic Product, or GDP, which is an approximation of the final output, in money terms, of all economic activity. GDP has become a global standard as an indication of a nation’s wealth, primarily because it’s the only measure widely available and, when adjusted for the purchasing power of different currencies, allows for a useful comparison between countries.

So the GDP figure has become important as an indicator of the health of a nation, as well as its wealth – if the figure rises, we have a growing economy, which governments and economists think is good; and if it falls, we have a recession, which is bad.

Things are not quite so clear-cut as this might suggest, however. For a start, GDP figures are not a very good indicator of a nation’s real wealth, as I will explain in Chapter 4. In addition, growth cannot go on forever, because before very long, almost certainly during this century, we will start to run out of resources.

Rich Mother Earth

Real wealth comes from the earth. It always has done and, as long as there are human beings living on this planet, it always will. The problem is that, at some point in recent history, we lost sight of this fact. We came to believe, for example, that the financial sector of the economy created wealth, when all it has ever done is to shift wealth around. It creates money, but that is an entirely different thing. In fact, creating money is part of the problem.

From a time before the human race had developed enough to have anything resembling an economy, and indeed right up to the middle of the last century, most people would have understood that real wealth had to come from the earth. What would we have, if we had not grown the crops, reared the animals, caught the fish, chopped down trees, dug minerals and fuel from the earth? Nothing.

Well, that’s not quite true, of course. We’d have a pristine natural environment, so in that respect we’d have everything, but we’d still be living in caves and eating grubs. Looking at this in purely economic terms, we’d have no economy, no ‘assets’, no wealth in the accepted sense.

We are products of the earth. We dug raw materials from the earth and, using human ingenuity and labor, we added value to those materials – we turned the earth’s natural wealth into something useful. Through industry, we turned crops into food, reared livestock on the soil’s bounty, turned animal skins, flax plants and cotton into clothing. We built houses and factories from timber and stone and clay, learned how to make cement from limestone, how to make steel from iron ore. We invented machines that made it possible to make more things more easily, using coal, and later oil, as fuel. And all of this came from the earth, to be enriched by human ideas and hard work.

A simple equation:

I don’t mean to imply that this is a mathematical or scientific equation; the values are not absolute, rather they are concepts with variable optimum inputs. The main point is that neither the raw materials nor the labor have what we would call ‘value’ by themselves. The gold or iron-ore buried in the earth, the undisturbed soil or the virgin forest: this natural wealth only acquires its value, to us humans at least, when we apply human labor and turn it into something useful. And the labor itself is useless without the natural resources to work with.

So we see that no wealth can be created without both materials and human effort, and this has important implications for the future, as technology makes industry ever more productive.

Whichever way we look at it, there is no economy until we extract the raw materials from the earth, and this would have been perfectly clear to anyone who cared to give it some thought, until economics started to get more complicated, say around 50 years ago. At this point some of the more obvious truths began to get submerged beneath a rising tide of prosperity, and beneath the corresponding rise of the service sector, which now employs over three-quarters of the workforce in many Western countries, yet creates no real wealth.

This brings us back to one of the fundamental problems affecting the major economies of the developed world. In order to understand this problem fully we must first endure a brief lesson in simple economics.

Back to basics

In traditional economic teaching, the economy is divided into three sectors: Primary, Secondary and Tertiary.

The Primary Sector is concerned with the extraction or harvesting of natural resources and includes agriculture, forestry, fishing, mining and oil-drilling.

The Secondary Sector is concerned with turning these raw materials into something useful. This means industry – processing, manufacturing, construction.

The Tertiary Sector is everything else, and is usually referred to as the service sector. It includes retail, transport, finance, marketing, healthcare, leisure and entertainment.

Sometimes these days a fourth sector is added to cover knowledge-based intellectual services and government activities, but this is an unnecessary complication. To create a new category for them is to miss the main point of the original three-sector classification:

1) Take the natural wealth from the earth.

2) Use human ideas and labor to turn that wealth into something more useful, thus adding value and producing ‘tangible’ wealth.

3) Distribute that wealth amongst the population through payments for services, thus creating a wider economy.

Certainly there is a lot of crossover between sectors: industries such as publishing and information technology, for example, have large elements of manufacturing as well as services, and some big oil companies straddle all three sectors. But the main point still stands: are the majority of workers productive or non-productive? Or, to put it another way, do they work mostly out on the land or in factories, or do they work in shops and offices? It used to be classified by clothing – blue-collar or white-collar – but that distinction has faded with time, and with the T-shirts and jeans of Silicon Valley.

This is all very simplified of course – a significant proportion of service workers drive trucks and buses and trains, for example. Another distinction can be made between private and public ownership. In the US and Europe these days, most direct government employment is limited to the service sector, in areas such as social welfare, health, education, defense and law enforcement. In many other countries the state owns major oil companies, aircraft manufacturers and so on, in which case it is involved in productive wealth creation. But the type of ownership doesn’t affect the points I’m trying to make.

As an economy develops, more raw materials are taken from the earth, more crops are grown and more goods are produced, resulting in overall growth in the economy and continued expansion of the workforce. Figure 4 shows how the world’s population grew in the 20th century, and how that growth was supported by the extraction and harvesting of the earth’s natural wealth.

Figure 4

As the population grows, demand for goods increases, more jobs are created and the cycle feeds itself. As Henry Ford understood when he raised wages so that his employees could buy Ford cars, the workers are also the consumers.

A developing economy moves from reliance on the Primary Sector, through an expanded Secondary Sector until eventually the majority of its workforce is engaged in the Tertiary Sector.

This transition occurs because human ingenuity, when applied to the needs of these developing industries, leads to increased mechanization, which brings productivity gains in the first two sectors. The wealth of an industrial society accumulates over time, and this wealth supports the growth in services.

Figure 5 illustrates the development of the US economy from 1850 to the present day. We can see the trend away from working on the land, the rise and fall of factory work (with a boost during the Second World War) and the eventual domination of the service sector. This can also be read as a move away from the wealth-creating sectors to the wealth-distributing sector. We see also how the trend begins to flatten out as the development cycle reaches its limits, or even overshoots its limits, as I will explain later.

Figure 5

I use the US as an example of a developed economy because of its size and the variety of its industry, and also because it provides reliable historic data, but the pattern for countries such as Britain and France is similar. We can see the same pattern in a different way by looking at three countries at different stages of development in 2010, as shown in Figure 6.

So most developed countries these days rely overwhelmingly on the service sector for the bulk of their economic activity, and especially for employment. There are a few exceptions to this rule, however. Canada and Australia, for example, have large mineral-extracting industries, and the German economy still has a substantial manufacturing base. And it just so happens that these three countries were less affected by the crash of 2008, because they earn more real wealth. Germany exports high-value goods such as cars and machine tools to the booming economies of China (where there is new wealth from manufacturing) and Russia (which has wealth from oil and gas).

Figure 6

I would suggest, therefore, that the economic problems affecting most developed nations today are primarily a result of the decline in the primary and secondary sectors relative to their overall economies. Too much reliance has been placed on the service sector for employment, and, although during the boom years the service sector created millions of well-paid jobs, the wealth still had to be created originally by the primary and secondary sectors. We lost sight of this fact.

We came to believe that the financial services ‘industry’, for example, created wealth, when all banks really do is take wealth that has already been created in the real economy, much of which is now held in large investment funds (in other words, other people’s savings and pensions), and try to profit by lending that money, or by borrowing more money against it (leveraging) and speculating in things like derivatives, in the hope of making still more money. But this whole business, which according to GDP figures adds around five trillion dollars a year to the global economy, does not actually create a penny in real wealth. The nature of derivatives, which form the bulk of financial trading these days, is such that when one trader gains, someone else must lose. This is comparable to the more obvious forms of gambling, only worse, because the loser might not be another gambler, but rather an innocent investor, or pretty much anyone (more on this in later chapters). Does the betting shop or the casino create wealth? Of course not.

So that five trillion dollars wasn’t really new wealth at all – it was a combination of wealth that already existed and credit that had been artificially created by leverage. A lot of that existing wealth will have crossed international boundaries, so in that respect nations such as Britain and Switzerland gain, but, from a global perspective, financial services don’t create wealth. What they create is debt.

As the proportion of actual wealth creation in the economy declines relative to wealth that has accumulated from past industry, as it inevitably must do, the dynamics of the global economy change with it. The influence of the financial sector grows at the expense of the productive sector, with unfortunate consequences for the majority of the world’s population.

Yes, banks provide a useful service to industry, and have done for thousands of years, but since the 1970s, after money lost its link to gold, the bulk of banking activity has been increasingly detrimental to the economy. If it weren’t for the rapid growth of the financial sector, the last recession would not have happened – or at least it would have been a lot less severe, and the Eurozone wouldn’t be in the mess it’s in now. The credit bubble gave us artificial growth, and now we must return to reality. The value of the dollar, and currencies generally, has been falling, and will have to keep falling until the amount of supposed wealth in the world corresponds to the amount of real wealth that’s been created. This has serious implications for the global economy over the next decade or two, as the long-term trend for falling prices, as shown in Figure 7, goes into reverse.

I’ll return to the issue of rising prices later, but first I want to think a bit more about the balance between the productive and non-productive sectors.

Figure 7

Different kinds of wealth

Perhaps I should clarify this point about wealth creation, because although in some respects it might seem obvious, I have a feeling that some politicians and economists might disagree with me when I suggest that what amounts to almost 80% of the British economy, according to GDP figures, doesn’t create any wealth. Is it really possible that 20% of the workforce – around 10% of the population – is supporting the rest of us?

Well, no, it isn’t. For one thing, Britain imports wealth from other nations via the City of London, and for another thing, as I’ve already mentioned, GDP figures give the wrong picture.

Let’s think for a minute what service jobs involve. Whether you’re a shop assistant, a hairdresser, a bus driver, a waiter, a banker, a marketing manager, you aren’t really creating wealth. All you are doing is taking money from your customers in exchange for a particular service. Even if you’re a doctor or a lawyer, a police officer or a judge, the same principle applies – you are paid for providing a service. That service enriches the economy, certainly.

A teacher, for example, provides an invaluable service. Perhaps more than any other worker, a teacher adds a great deal of what I referred to earlier as ‘intangible capital’ to the economy, and therefore to the nation. But the reason we call it intangible capital is that teachers add a kind of value that we can’t see or touch, and therefore can’t really measure. The whole nation – business especially – benefits from a good education system, which is one reason why we shouldn’t begrudge paying for it in taxes.

But it should be clear enough that, to pay those taxes, there must be some real wealth entering the economy. If everyone worked in education or the health service, or any other service, where would the wealth come from?

A more obvious example still is the army. For as long as there have been city states and other organized societies, there have been armies to protect them from attacks by ‘barbarians’ or rival armies. But armies had to be equipped and soldiers had to be fed, which meant either a raid on a neighboring state’s gold supplies or a tax on landowners, or possibly both. One of the first forms of taxation was the demand by Persian emperors and other ancient rulers for a portion of the harvest to feed the army. And effectively, this still goes on today: the produce of the earth, and of industry, is still the source of all government revenue.

That isn’t what the figures will tell you, of course. A breakdown of UK economic output as measured by GDP suggests that less than 1% of the nation’s wealth comes from agriculture, 16% from manufacturing and over 30% from financial and associated services. Most of the rest comes from other services. So if Britain is a nation of shopkeepers and bankers, where does the real wealth come from?

Investment banking is totally dependent on large funds of accumulated wealth, all of which must have come from industrial activity of some kind. It’s not easy to trace the source of private wealth, but there are enough clues around to give us a general picture. A lot of the money that finds its way into the City of London, for example, originates in Middle Eastern oil or Siberian gas fields.

In fact, as I will explain in more detail later in this book, more than half of all wealth in the world today has come from oil.