Sunday 13 April 2014

One.. Two... One-Two-Three

There are some very strange ideas floating round on the interwebs about the cornerstones of all economic debate - goods, services and money. This is an attempt to straighten out some of the more blatant misunderstandings.

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The Three Sectors

Economic theory tends to break economic activity down into three segments, imaginatively named Primary, Secondary and Tertiary. This can a useful distinction when categorizing different economies, more "developed" economies tend towards a higher proportion of activity occurring in the secondary and tertiary sectors, and this has other uses in discussing how particularly industries may rely on others. It was never intended as a measure of how "good" or "useful" a certain industry is. In economic terms an industry (either a particular company or group of companies) is ""better"" (in a huge string of inverted commas) if it produces (adds) more wealth than another industry, regardless of where on the 1 / 2 / 3 scale the industries in question sit.

To briefly clarify;

Primary industries deal directly with natural resources. This therefore covers things like mining, forestry, farming, and oil and gas extraction. Under-developed nations tend to have a lot of primary economic activity because it (generally - oil and gas being the exception) can be undertaken with a labour heavy base rather than a capital intensive one.  The "value adding" component of the primary industry is predominately a function of location - iron ore in a warehouse is worth more than iron ore a mile underground even though the object itself hasn't changed.

Secondary industries deal with manufactured goods. This could potentially be broken down further into 2.1 and 2.2; 2.1 industries take the output from the primary industries and create manufactured goods (i.e. take iron ore and turn it into iron bars), while 2.2 industries take manufactured goods and use them to create more complicated manufactured goods (take iron bars and turn them into knives and forks).  The value adding component of secondary industries comes from the increased utility the same amount of physical material can have in different forms. (In the example above 10 sets of knives and forks has more value than the pure value of the metal because the form has a function).

Finally the tertiary industry deals with services. An exact definition of what a service industry is can be a little harder, though I'd take a punt that services deal with where and when things are rather than what they are. As an example a transport company provides a service - i.e. moving your 1,000 tonnes of wheat from point A to point B; they haven't changed the product, but they have changed where it is, thus adding value (it has practically speaking very little value in a barn on a farm, but potentially enormous value as the input to a corn-flake factory). The value adding component of the service industry is allowing the utilizing goods.

It should be pointed out that these definitions are a little blurry round the edges - this isn't really that relavent and shouldn't be used to derail the general thrust of this piece, but its something to be aware of. (For example you could argue mining is changing the location of an object and hence a service industry, although intuitively we all accept that a copper mine is doing something different to UPS  though on paper they are both moving an object from A to B, likewise the distinction between utilizing a set of goods to add value (service) and manufacturing a new good (secondary) could be blurred).

I'm going to take a slightly tangent here to talk about what value actual means.

Value, Utility and Moneys

 In economics the term utility appears, and while sufficient for the purposes of economics-as-maths and as a placeholder word for a general concept in economics-as-social science, it often gets mistranslated into common English. Utility is roughly speaking the benefit we get from consuming a good or service. Somewhat unfortunately this will be different for each individual. While I will derive some benefit (happiness, pleasure, etc) from eating a cake, there will be other people who would have got more or less benefit had they been the ones eating the cake. This conundrum presents all kinds of problems for economists since it undermines the idea that a group of rational agents presented with the same choice will make the same decision. (For example do you want this piece of cake or this piece of banana, I would pick the cake, others would pick the banana, but we are both acting according to the same utility-maximizing principle).

 To circumvent this principle economics often equates utility which is person-specific and difficult to quantify (happiness is best seen ordinally rather than cardinally - i.e. you can say you were happier in situation A than in situation B, but not by how many "units") with money. Money is great since it is easily quantifiable, easily observable, and, in the modern market place, easily transferable. The idea is that while there will be specific combinations of items valued at £10,000 that any given person prefers over other 'baskets' worth £10,000, having £11,000 will always allow you to have a higher total level of utility than £10,000. (Fuzzy indifference curves aside).  The risk however is that in the world of faux-business that passes as "man down the pub / man on a forum" economic debate money gets seen as the end in and of itself, rather than as a proxy for the consumption of goods and services.

So, to reiterate; money is not value. Value is a measure of utility. Money is a proxy for value only.

In practice this means that when assessing the output of an industry and ultimate question is how does this make people happy - that is, give them utility. Not how does this industry contribute to the circulation of the bits of coloured paper that we use as a medium of exchange.

"Winning" at trade

There have been plenty of people through history (and indeed in the modern world) who have acquired vast fortunes through trade and business. Though to those who cry out against the perceived wealth inequality between the "1%" and the rest in today's world, it may be worth checking out the equivalent in today's money of the fortunes accumulated by the original barons of industry, (whether it be textiles, ironworks, railways or whatever) and historical rulers (wiki has a somewhat dubious claim that the Roman orator, general and politician Crassus may have accumulated a personal fortune equivalent to the annual Budget of the entire Roman Empire. Based on some very dubious extrapolations compared to the gdp of the British Empire (which had a comparable % of global population and technology), this would be equivalent of 1.3 trillion dollars in today's money - that's 17 times more than Bill Gates, or about 2.5 times the combined wealth of today's ten richest billionaires.).

There are two ways you can acquire wealth through business/trade (through all of this I'm ignoring the distinction between you personally, and "you" in the sense of a business you own. It's now a meaningful distinction in this context). 

The first is to take some inputs (say iron bars, timber, gravel, nails, and largely unskilled labour), and turn them into something which has more value then the inputs themselves had (i.e. a railway network). Through this process the total aggregate value of all the goods and services in the economy increases, i.e. the total cake gets bigger. A canny owner/businessmen can pocket a significant chunk of that increase for himself, thereby becoming fantastically wealthy. But the point is he has created value. The railway example is very informative - imagine you are a dairy farmer, you sell milk. Without a railway you can only sell to the nearby village and other farms, and you'll end up throwing away a lot of milk you can't sell (particularly since your likely to be surrounded by other dairy farms). Along comes the railway and suddenly you can sell you milk (remember this is fresh milk before refrigeration etc) in the nearby town, which will always have someone looking to buy it. Net result? You get to sell more of your product and make more money. Of course you have to pay to use the railway. So lets say you make an additional £15 a day from selling your goods, and you have to pay £5 of that to the railway. Your still better off, potentially a lot better off. But the guy who owns the railway? He make's £5 of you. And the next farmer, and the next, and the next, and so on, until he's earning hundreds of thousands every single day.

This is capitalism as it's meant to work - you create value, and in doing so you get to keep some of it, and some of it flows out into the economy benefiting others. (Indirectly all that money you keep for yourself still has a benefit, since it means you'll consume more goods and services yourself, thereby creating work for others). The key to the genuinely mega-rich in this process is to come up with something that benefits everyone, so you get a bit of value of everyone. Railway became a service consumed by the entire economy, so the barons got their slice of every cake in the country. Bill Gates made his fortune of Windows - a system which virtually every computer on the planet uses.

"Cheating" at trade

The alternative is to take some inputs (a bank account, an advertising budget, and some fancy linguistics) and  create a product with no value ( a ponzi scheme), and then get people to buy it.

The idea here is that you got more for the product then its worth, thereby pocketing the difference. Note - this isn't you got more than the inputs are worth (which is true of any value adding industry), you got more than the finished product is worth.

What should hopefully be apparent is that this system relies on some form of deception, often deliberate - it relies on convincing people things are worth more then they actually are. Going back to our point above about value, at heart this means telling people that products or services will do something that actually they won't.

The ponzi scheme is an example of a financial product / service, that offers to take your money and give you back more money at some future point. Fine, that's the basis of virtually all investments, but the ponzi scheme is predicted on a disparity of information - the person running the scheme knows full well that the "product" has no real value since it will never return any of the money. But the investors don't know this , and therefore complete the purchase. 

Cheating at trade does allow you to get rich, but the overall size of the economy hasn't changed. Blank DVDs don't gain "real" value (i.e. they don't add more utility when consumed) by being packaged up in movie boxes and sold as films. Thus this type of trade is about shifting value from one person to another, not creating new wealth.

As an aside, generally you don't get super rich with this approach - why? Because it relies on continually deceiving people and 1.) people are harder to trick as the amount of money involved goes up, and 2.) it gets harder to trick people a second time.  A function of a wealth creating industry is that it encourages repeat use. In the example of the dairy farmer above, having gone to market, sold your milk, and got home with a profit, you are more inclined to do it again, i.e. when you get some more product you will make use of the railway to again increase its value by taking it somewhere you can sell it. On the other hand if the railway were a "cheating at trade" idea - (i.e. if there were no trains so you can't actually move things, or maybe you can't get out at the other end ??), then you won't do it a second time.

Value is Perceptive

A clarification is required here, to distinguish two different concepts.

1.) Promoting and advertising a value adding product

2.) A cheating at trade (value-reallocating) product.

Having created a product (iphone, Imperial Knight titan, chocolate cake), you naturally want people to part with money in exchange for the product. Advertising lets people know your product exists, and promotes its benefits and features. The price you set will be as high as you think people will pay. However we have a concept of "fair" or "honest" advertising. It is considered an institution of trade that you can't flat out lie about your product to encourage people to buy it, and if you do consumers have various rights of recourse to get their money back.

Examples flash by on a fairly regular basis, though they are generally on the grey areas round the edge - yes the product will do what's advertised, but only in certain, unlikely circumstances. Hence we have the term "misleading" advertising. This is promotion taken the extremes, with the positives stressed unreasonably, and the negatives covered up. Personally I may dislike the extent to which this occurs, but it is still (just) in the realms of "winning at trade" - your product does have advantages and does create value. You've just exaggerated to what extent and for whom.

"False" advertising on the other hand is the precursor to "cheating" at trade. Adverts for a color TV that is actually black and white, for a 3 for 2 offer that actually only includes 1 product, or books that turn out to be full of blank pages, would all quickly fall foul of "cheating" at trade. The distinction here is you are advertising a benefit that doesn't exist.

A few points then;

Banking and Financial Services

I often come across claims that the Banking sector doesn't add value, it just re-allocates value from customers to bankers. In effect the claim that it is part of the cheating camp. To begin I'm going to split off the fantasy world of derivatives trading and investment banking. Yes, I can quite accept that the trading world is focused on exploiting knowledge inequalities to sell things for more than they are worth by apparently offering benefits which you full well know don't exist. However the people in this world know the "rules of the game" and are not part of the regular consumer/producer market. This is not unlike going to a poker tournament and then complaining all the people there were trying to win your money off you.

"Retail" i.e. everyday, banking, adds value in a huge range of ways;

1.) It provides a safe, secure, easily accessible way to keep your money. Imagine if you had to keep all your money as notes under the bed, and your life savings as either gold or coin in your house.

2.) It allows access to the electronic payment world - direct debits, standing orders, debit and credit cards and so on are all services that allow you to easily manipulate when and where your money is.

3.) It provides a method of borrowing money to bring forward future consumption. On the whole I would conjecture banks are pretty clear in their advertising of how much you will borrow and how much you will pay back. It is then up to you to decide if that cost (i.e. the interest) is worth the value (whatever it is your planning on using the money to acquire and consume).

4.) In climes more typical than today's 0.5% BoE base rate world, it provides a low return, ultra-low risk investment (bank deposits are liquid investments in the bank. But they are incredibly safe since it would require an insolvent government before regular deposits were lost).

One of the points I raised in the "value adding vs value stealing" sections was that a value-adding industry attracts repeat (or ongoing) business, while a value-stealing one finds it difficult to get people to re-use or re-purchase a product once they know what they are really getting.

So, if banking is such a huge scam, with no benefit to the regular user, why does everyone have a bank account? Why do people still want to take out mortgages and credit cards? Why is the complaint not so much "we don't want banking" but "we don't want to pay for banking?".

The PPI scandal bears some consideration here since it appears to meet the above criteria for cheating ("having found out what it is I don't want it anymore"). Without risking an entirely new topic, I would suggest the consideration is not so much the product itself, but how it was sold. A mismatch can occur when a customer doesn't realize they are in a sales conversation.

Two examples:

1.) You go to a used car salesman and he tells you XYZ car is brilliant. You know this is a sales pitch (advertising) and therefore to be careful to check the product is what you expect. Its unlikely your being directly lied to (i.e. car has a year's MOT when in fact it failed its MOT), but your probably getting the best possible version of the truth.

2.) You go to the dentist and they tell you you need XYZ treatment. Here you expect your being informed as to what would be best for you, not being given the spiel on a particular product. We expect medical professionals (and legal, mechanics etc), to be acting in an advisory capacity not a sales capacity.

Now imagine the problem that arises when the customer thinks they are in situation 2.) and the salesman thinks its situation 1.).  The general public, who until recently, largely saw the banks as social institutions, if not an extension of government, would have sat down with a customer service rep, and probably assumed that if they were offered a product it was a good idea to take it, in the same way that if your dentist says you need a filling, you assume he's acting in your best interests. On the other hand, the CSR, who has sales targets, sales coaching and a sales focused job description, sits down to the same meeting with the intention of shedding the best possible light on his products, and assumes the customer knows they are being sold to - in the same way that the salesman in PC World or Currys knows that the customers knows its a sales pitch.

This then leads to "mis-selling" scandals.

Do I have much sympathy for people who were given the details of a product, read them, decided they wanted it, then changed their mind? - No. This is a straight case of your making a judgement on the value you get from different baskets of goods then changing your mind.

Do I have sympathy with people who thought they were being advised, but were in fact being sold to? Yes - to some extent. Though ultimately you still bought a product, and you probably weren't actually lied to about what it did.

Finally, do I have sympathy with people who sought financial advice and were told to buy a product they didn't need? Absolutely - this is a cut and dried case of "value by cheating". If the service you sell is financial advise, and your giving people bad advice driven by your own targets or commissions, then your being misleading when you advertise "advice".

All hail Manufacturing

I was going to end with a comparison between the German and UK economies in response to the perennial racket that we should shift back towards manufacturing because somehow manufacturing is more holy than financial services. However, this is probably a topic that justifies its own post, so a few observations only;

1.) Yes Germany has both a bigger manufacturing base, and is the worlds top exporter.

2.) Yes there does seem to be a trend that western countries export pretty much all of their manufactured goods.

3.) The causation on the above is not clear. This could simply be saying we've shifted labour and capital out of manufacturing to higher value-adding industries and used the money to buy cheap manufactured goods from other people (China, Taiwan etc). The manufacturing that has remained is the capital and skill intensive industries which are primarily exporters by nature (automotive, aerospace etc). Therefore pivotting back to semi and low skilled manufacturing will not add a great deal of value, though it might improve the balance of trade position.

4.) Germany has an artificially low exchange rate thanks to the Euro, which boosts its export capacity.

5.) German work and investment ethics are far superior to those in the UK. It doesn't really matter whether your in manufacturing or servicing, a culture which promotes skills, training, experience, and inwards investment will have solid fundamentals. Germany excels in these areas. The UK does not.

6.) We could focus on making our services an exportable commodity. If we are good at financial services then specialize in that and sell it globally. Someone once said "not everyone can sell insurance" - this is true. But there is no reason why one person/country can't sell everyone's insurance. Maybe we should be looking at how to sell what we do have, not what we may theoritically have if we re-build the whole economy.



Conclusion (the TL;DR version)

You can either dig stuff up, turn stuff into other stuff, or make people's lives easier. They are all value adding. Proper capitalists create value and get rich by getting a slice of a growing cake. You can cheat by misleading people over your products, but this isn't how stable, ongoing industries operate. And no, everyone making chairs isn't a superior position to everyone selling insurance.

Happy Trails,

/Z





 












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