How Is Wealth Created?
In order to answer How Is Wealth Created? Let me try to explain it using a story. Let’s imagine a world in which suddenly all the tools disappear, all buildings, cars and machinery or even basic tools such as knives hammers and shovels vanish.
What would the economy look like? Especially if we had to do all the work with our bare hands. This is the situation in which the hero of this story used to live – on a remote island, he was a fisherman. Perhaps, fisherman is too strong a word because in a world without tools, his fight for survival was to jump into the sea and make desperate attempts to catch fish with his bare hands.
It was not an easy life. All this effort resulted in catching just one fish per day which is just as much as he needed to survive one night. Completely wet, eyes sore from the saltwater he lay on the beach staring at the Stars. Thinking about how he could improve his life, he suddenly came up with a brilliant idea – If he could just extend the reach of my hand I might be able to watch the fish from above the water and probably be able to catch more.
He decided that in the morning he was not going to catch a fish, instead he would devote this day to implement his plan. He searched the woods looking for a strong straight branch which with great effort he managed to break off and then with a sharp shell found on the beach he tried to sharpen the tip of the stick. It took him many hours but finally that evening he fell on the sand exhausted from hunger. He hadn’t eaten anything the whole day, focused instead totally on his new invention. Although hungry, he was happy because in his imagination he was already sitting on a heap of fish caught with the help of his new spear!
The following morning, motivated, he grabbed the spear and began to work. As the salty water did not flood his eyes any more, he pointed the end of the spear and was immediately more effective than his hands. He was able to catch two fish that day – it was not a heap of fish yet but the economy of the island did just grow by 100%. More importantly it opened up for him many more possibilities, he was now able to fish every second day consuming his catch from the previous day. He could also go fishing every day as before and dry the excess fish and store it for worse time.Another option was to use the free time to implement new ideas and to increase his productive capacity. This would result in increasing his wealth and expanding the size of the island.
With the islands economy in this story we come to a simple economic principle:
Wealth is created through self-sacrifice and taking risks.
The fishermen under consumed and took the risk that his plan might not work and that he would go hungry all day producing the spear. The fisherman’s under consumption can simply be called saving.
In this case the saving was a fish – which he would surely have caught if he had gone fishing he used his saving to make a spear. The spear is a capital good because it is part of his saving which is no value in itself for the fisherman. But it serves him to get what he really wants, i.e. the fish.
Let’s fast forward to our world to illustrate this example in real life, two friends got a very well-paying job in a company called corporation X the employer offered each of them $10,000 a month. Not believing his luck, one of them let’s call him prodigal Pete immediately bought a big house with a garden on credit, the monthly rent amounted to $3,000. He also bought a luxury car, also on credit which he paid $2,000 a month bills. Hiring a gardener and a cleaning lady meant another $2,000, with the remaining spent on eating in fancy restaurants and hanging out with friends – who surprisingly became more numerous after he got the new work. At the end of the month he had no money in his account leftover.
Meanwhile, his colleague Tom knew the story of the fisherman that was told in his family for generations. So after getting a job he rented a medium sized apartment for which he paid $1500 because he thought that currently the apartments were too expensive to buy. His monthly ticket for the subway cost one hundred dollars and the other bills for the apartment amounts to $400. Tom also liked to dine in restaurants and meet his friends but he decided that for his entertainment he would spend no more than $500 a month – most days he ate meals at home trying not to waste food which cost him another 500 dollars.
This way thrifty Tom could save 7,000 dollars every month! Years passed and Pete was laughing at Tom, he used to say to him get a life man – stop being a Scrooge or how’s your car? oh sorry, I forgot you were still using the subway. Tom felt upset because he dreamed of a big house with the garden and a luxurious car but common sense took precedence over whims.
He invested his savings in various projects, he opened a small shop in the area where he hired one employee. After paying for all the costs his profit amounted to one thousand dollars, still however, he did not increase his spending. After some time he opened a restaurant from which he drew profit of $2,000. Later he bought a bit of real estate, partly on loan, which he rented to various companies as office space. His gains after his loan payments amounted to $4,000.
Tom kept at it and after a while his gains from all of his projects was already $15,000. Suddenly, hard times fell upon corporation X – because of some bad choices and a global recession, it had to fire 2,000 employees, and among them were Pete and Tom.
Tom suffered a slight scratch on his honor because no one likes to be fired, but other than that he didn’t care too much about the situation. He had an income of the amount of $15,000 per month from his investments in a large amounts of savings. Pete on the other hand panicked, the bank demanded payments on a loan which Pete managed to pay only half. Friends invited him out for the first week but when they saw that Pete had financial problems the invites began to fade quickly.
Pete borrowed money from family to survive but during the economic crisis no one wanted to accept him and certainly not for the high salary he earned before. Finally, Pete decided to sell his car because he was not able to make the minimum payments. The value of the car although it was in perfect condition fell dramatically as it was a few years old and no one wanted to buy it because people kept their money uncertain of their future. The house lost its value because Pete bought it at a time of great prosperity and high availability of cheap credit, which pumped up the prices of the property. Due to this, it turned out that the market price of his home and the car were as much as the value of the loans which Pete still had to pay.
He was really hurt by the fact that for so many years he was paying the loans and now he was left with nothing and he still had to sell because he needed the cash right away. After a few days Tom called him so that he would buy both the car and the house, during the transaction they talked for a while as old friends. Pete told him about his situation and Tom as a man full of empathy said, listen my friend I was just going for an early retirement and I need someone capable to take care of my business. I know you were a good specialist how about I hire you for $3,000 a month, Pete felt relieved- finally someone wanted to hire him. He was no longer burdened with loans and he accepted the job from Tom. He rented a small apartment and began to save.
The story of the fisherman was based on the excellent book by Peter and Andrew Schiff how the economy grows and why it crashes we encourage you to read it if you are interested in the conclusions of the second story you can read them on our website econ clubs comm I encourage you to subscribe to our You Tube channel and like our Facebook page you can find links in the description below