I’m going to geek it up today and talk about a couple ways that economies grow – import replacement and new work. Both are very applicable to the current US and world economy, but we’re going to start examining them by looking at a new and simple economy.

Let’s take a new village created around a gold mine. It earns its money by digging up ore and shipping it out. Everything in the economy is imported in – the booze, the mining equipment, the food, equipment is sent to be repaired, clean water is trucked in – heck in some cases even the laundry is shipped out. If we assume the economy is earning 100 million a year, probably 90 million of that is flowing right out.

The something interesting starts happening. The bathtub rum guys get good enough to set up their own microbrewery. Someone starts farming nearby. Others start repairing the complex machinery in in town. The village drills down to an aquifer and starts piping that out to residents. All of this is import replacement – things which used to be imported from outside the economy are now being created

So, instead of 90% of the economy’s money flowing straight out, maybe it’s down to 70%. And that additional money that stays in the economy can be used to buy more outside goods, or can be saved to start up new businesses. Probably it’s used for both. So maybe they start importing fancier stuff – dvd players, better filtration equipment for their water, and so on. Maybe they hire some engineers to come in and build infrastructure – a sewage treatment plant, a better road system, a deepening of the local harbor and so on.

Imagine that the mining community has its own currency and think about what’s been happening with their currency during this. When they started import replacing, they used less of their money to buy outside goods. Since that was the case, their currency became worth more. As it became worth more it became possible for them to import more goods – for less, but as they did, the currency then dropped in value, making it more expensive to buy outside goods – and making any goods they might sell to the outside world worth more.

And that’s when a couple other interesting things happened. The microbrewery, having had to brew using substandard conditions and local flora turned out to have a product unlike anything anyone else had, and there was enough money saved up to build it up so it could produce more booze. The community started selling the booze to the world, and instead of just having money coming in from the mine, it now had money coming in from liquor sales. And some of the mining engineers figured out a better way to extract ore. They left the mining company (their state being smart enough not to allow non-compete clauses in contracts), started up their own business, and started manufacturing the necessary machines for their new mining technique. They then sold that equipment and the expertise for using it (but not for manufacturing it) to the outside world. Even more money started coming into the community.

And the local currency, with more money coming in, appreciated. The community then did another round of buying new, more upscale imports – an upscale auto dealership opened up in town, more fancy electronics goods came into town and so on. In reaction to that, the currency dropped in value, and some local businesses started up to provide some of the more fancy goods – some technicians from mining company, who work on microelectronics, split off to set up a company creating consumer electronics goods whose selling point is hardiness. Lots of small companies making parts for both the mining company and the electronics company spring up, so they no longer have to buy those parts from outside, and indeed they start exporting those parts beyond what is now, not a village, but a city.

And our new city has grown in three ways. First there was the original resource – the reason for existing. In this case that was a mine, but it could have been as an entrepot town (say having a harbor, or being at an intersection of shipping lines, whether rail, road or river) ; it could have been a fishing town; it could even have been the center of an agricultural district. From there it first used import replacement to reduce the amount of money it was spending on outside goods. Next it created new work, a new product or industry – in this case a new type of booze, and a new way of mining plus the equipment that went with it and exported those things to the world. Part of what made that possible was the money saved in the community by increasing the savings rate through the earlier import replacement – keeping more money in the community. Then it increased imports which is actually part of the cycle of growth, because it allows the community to learn about new goods to either import replace them, or to create new work. Both of which happened with the creation of the electronics company (new work, plus import replacement) and the myriad of small suppliers (import replacement, plus new exports). Through all of this, in our simplified model, currency was applying feedback – telling the community when it could afford to import more stuff, giving it an export subsidy when it had imported more, and an import subsidy when it had created new wealth. (In the real world as it currently stands, where major countries manipulate their currency with massive interventions, exchange rates don’t give accurate feedback, though they still give subsidies for one activity or another – the Chinese Yuan, for example, is set at a concessionary rate to act as an export subsidy and to encourage the Chinese economy to do income substitution. The US dollar currently does the reverse with respect to most Asian economies.)

Now that we’ve seen how an economy grows, let’s see how it can shrink. Our city, let’s call it Aurelia, has had nothing but growth. But two things have happened – the cost of being in it have gone up (higher living expenses, higher taxes, higher property values) and the company creating the mining equipment has figured out how to turn it into the turnkey operation that can be done entirely in-house. The technology is now mature, it no longer needs to be located next to the miners and engineers who are working the field, figuring out new tweaks, and so on. As such, it no longer makes sense to keep it in a place that costs a lot – it’s not necessary, and all it does is increase costs. So they close down their manufacturing operations (but probably leave their headquarters in Aurelia) and set it up in a place with a cheaper currency, in the countryside where expenses are lower (but still near some rail or sea lines for transport). The economy of Aurelia contracts – less money is coming in, and indeed, now the local mine has to buy the mine equipment it needs from outsiders. The currency also takes a dip in value.

That dip in value is a feedback mechanism. It makes it easier to do import replacement (because imported goods are now costing more) and it makes it easier to create new work and export it to the rest of the world. In a properly functioning economy, that’s what happens – someone starts manufacturing goods that were imported, or creates new work, the currency value goes back up, and the economy hums along in alternating cycles of creating new work/import replacing, sending mature industries out to cheaper domiciles, and importing new goods which are hopefully fueled for possible future import replacement periods or which help new work be created.

Now this is a theoretical model. That’s not to say this isn’t how the world works – it does, sort of, and there are many examples (Silicon Valley, Manchester, Massachusetts at various time, Chicago and New York manufacturing, Detroit, etc…), but there are also many cases where it fails, and a city, or country, loses the ability to continue the virtuous cycles.

And this model is a useful one for looking at the economy in the world today. Let’s take a very brief look at this, starting with China. What China is doing today is keeping their currency artificially cheap (they spend about 10% of GDP on currency intervention, which is a massive number). Cheap currency means imported goods are more expensive, which means it encourages import replacement in a big way. Cars, consumer electronics, ripped movies, etc… it makes sense to make them in China not just because China has cheap labor, taxes, etc… but because China has cheap currency. So China gets huge amounts of growth both in import replacement (for internal consumption) and in export led growth. And when a mature industry, in, say, America – like most manufacturing industries, looks at where they should move their plants, China has a significant advantage in getting them, which is why China is a main offshoring destination.

The US, in the meantime, has an overvalued dollar against China (and the other major Asian currencies). That means instead of getting feedback that says “it’s time to import replace or to create new work”, the feedback that the US is getting says “you should be importing goods and shipping out mature industries.” That, of course, is what is happening. And since it’s happening in huge amounts, the US savings rate is actually negative, meaning that to do new work, to import replace, American has to actually borrow money from overseas.

Now currency feedback isn’t the only thing that matters – sometimes it will still make sense to import replace. Sometimes someone will still come up with an idea for new work, for a new product, that is worth doing and which because of supplier networks and other issues (often just “I don’t want to set up my business in a foreign place like China) is worth setting up in the US.

But in general the current atmosphere is not conducive to a huge wave of either import replacement or new work (the last great wave was the Internet boom in the 90’s). This should have been the decade that telecom really took off, but because conditions are extremely poor and because of regulatory and oligopoly issues (you can’t really innovate, because the majors simply won’t let you activate most features on their networks) it didn’t happen. Without that huge boost of new work, or of import replacement (the next big bout of which will probably actually be energy replacement) the US economy has essentially stagnated, with awful unemployment numbers, awful raises, and huge amounts of debt being taken on.

There are more lessons to be taken from this model, as well. Non-compete clauses, for example, are awful for economic growth (it’s not an accident that Silicon Valley is in California, with its restrictions on non-competes). Mature industries always head out for cheaper domiciles, it’s just a question of how far communications and transportation infrastructure – and political stability, allow them to do so. Small companies are where most new products come from. Concentrations of many small firms tend to give rise to more types of new work – to new products and industries, more than large monopolies or oligopolies (there are some exceptions).

And an economy which isn’t creating new work, new products, as fast as it is rationalizing old work, has a problem. As an industry matures what took many highly skilled people to do, takes fewer and fewer over time and it becomes, packageable, routinized – and thus able to be shipped away from the area that created it – able to be done by second raters who aren’t at the cutting edge.

And this, to a large extent, is the situation the US finds itself in.

EndNote

Those who are interested in this topic may wish to read Jane Jacobs’ The Economy of Cities and Cities and the Wealth of Nations which is where the general cycle is cribbed from.

Ian writes also for The Agonist