Blog | Personal Finance

What Drives Capitalist Growth?

meet your own rich dad - start your quiz now

In this blog, I would like to ask my readers to think about our economic system and how it creates economic growth. I believe this will be useful in understanding the impediments that will have to be overcome in the years immediately ahead if economic growth is going to continue.

Over the last 250 years, Capitalism has transformed the world. One way or another (some would say “by hook or by crook”) it has found a way to make profits grow and capital accumulate. Decade after decade, capitalist economies have grown by developing new production techniques, opening new markets (by force if necessary), finding new sources of cheap labor or, if need be, by demanding and receiving government support.

Many prerequisites must be in place for capitalism to take hold and to begin generating economic growth. There must be societal acceptance of such a system. There must be a sufficient supply of raw materials, including labor. Property rights must be secure. And there must be entrepreneurial talent. But the precondition that I want to draw attention to today is Effective Demand.

Here’s a definition of Effective Demand: “Wants, needs and desires backed up by the ability to pay.” And I have put “backed up by the ability to pay” in bold because that, of course, is the limiting factor. There may be no limit to human wants, needs and desires, but there clearly are limits to the ability to pay for them.

For capitalism to produce economic growth, investments must generate profits; and at least part of those profits must be saved and reinvested as new “capital”. One way for businesses to become more profitable is to reduce the wages they pay to their employees. Beginning in the 1980s most large US manufacturing companies began to push down the amount they paid to their employees by moving their factories to low wage countries like China and Mexico.

The problem with this strategy is that if all companies reduce the wages of their employees, then no one would have enough income to buy the products that the companies make, in which case profits will fall. In other words, there would be insufficient “Effective Demand” to allow the economy to generate profits and growth.

Between 1990 to 2008, this problem of insufficient Effective Demand in the United States (and in many other developed economies) was overcome by increasing the amount of credit ordinary people were allowed to borrow. Credit as a ratio of GDP grew from 220% in 1990 to 370% in 2008. With greater access to credit, Americans were able to continue spending more every year even though wages for most people ceased going up. Credit provided the Effective Demand that allowed the economy to grow.

That came to an end in 2008 when millions of Americans could no longer afford to continue paying the interest on all of their debt. When they defaulted they were cut off from additional credit. That caused Effective Demand to contract. And the contraction of Effective Demand threw the United States and the world into the worst economic slump since the Great Depression.

At that point, the government had to step in to prevent economic collapse. The US government and other governments around the world greatly increased the amount of money they borrowed and spent, thereby becoming the next source of Effective Demand. Part of the money governments borrowed came from the world’s central banks, which created trillions of dollars worth of fiat money over the past six years. That fiat money was one more source of Effective Demand. And, as a result of the increase in government debt and fiat money creation enough Effective Demand was generated so that our economic system was able to keep generating more profits and accumulating more capital and economic growth.

Where will the Effective Demand come from next? The governments of most of the developed economies are rapidly reducing the size of their budget deficits. The US budget deficit, for instance, is less than half the size it was at the peak of the crisis. Moreover, the US central bank, is winding down its Quantitative Easing program of fiat money creation, which is scheduled to end in November this year.

So, where will the next source of Effective Demand come from? As I look around the world, I can’t see any new source. Without increasing Effective Demand, profits and capital will begin to shrink and the global economic crisis will resume.

Capitalism, or whatever you wish to call our economic system, has been extremely resourceful in developing new sources of Effective Demand decade after decade. So, it will be very interesting to see how it responds to the approaching shortfall that now seems to threaten it. Let’s watch and see what happens. My bet is that Quantitative Easing won’t end this year. I expect the Fed will be forced to continue providing the Effective Demand that has been fueling economic growth in recent years. There does not seem to be any other alternative source.

Macro Watch


Original publish date: May 15, 2014

Recent Posts

Three Investment Values
Personal Finance

The Rich Dad Guide to Investing Values: Defining Your Path to Financial Success

It’s important to know which core values are most important to you, especially when it comes to the subject of money and financial planning.

Read the full post
Risky vs. Safe Investments
Paper Assets

Smart Investing: Understanding the Difference Between Risky and Safe Options

What you may think is a “safe” investment, I may see as risky. For example, many financial planners advise their clients to get into so-called “safe” investments — such as savings plans, mutual funds and 401(k)s.

Read the full post
Mastering Money
Paper Assets, Personal Finance

Mastering Money: The Key to Achieving Financial Freedom

Begin the path to making money work for you today, not the other way around.

Read the full post