How wealth is created

We are the lucky heirs of our fathers and forefathers whose saving has accumulated the capital goods with the aid of which we are working today.  We favorite children of the age of electricity still derive advantage from the original saving of the primitive fishermen who, in producing the first nets and canoes, devoted a part of their working time to provision for a remoter future…We are better off than earlier generations because we are equipped with the capital goods they have accumulated for us.  Ludwig von Mises    1949

With the exception of a few empires such as Egypt, Sumer, Persia, Carthage, Greece and Rome, for the first several thousand years of civilization, in most areas, significant wealth was not created.  What wealth was accumulated in some cities was mostly due to military success: conquered people and slaves were expected to provide wealth for the conquerors. Life in Europe, Africa and Asia from 5,000 BC to 1750 AD was more or less the same from year to year. The gross national output of any country or area was more or less the same from one century to the next.

The discovery of America changed that for some people. From 1620 to 1800, our forefathers in America produced real growth by working very hard, saving and investing. They cut down the forests to make farms. They built houses and barns, roads, schools and churches where before there was wilderness. But for the rest of the world during this period, there was very little economic growth. They did not have a new world to develop.

Then from about 1760 to 1800 in England, the industrial revolution was born. British entrepreneurs in textiles, iron and steel, and other processes discovered that you could get rich by saving your money and investing it in factories, canals, railroads, and agriculture. They unlocked a secret that had been hidden from mankind since the beginning of civilization: through saving and investment it is possible to produce capital. Using this capital in the division of labor, it is possible to produce vast increases in the output of useful goods and services.

The results of this industrial revolution were amazing to everyone who lived in England at that time, and to the rest of the world when the news got out. The revolution spread to every country in the globe. When it came, everyone could see the changes that it brought. Today, however, the process of creation of capital through saving and investing has become so much a part of our economic system that most people do not understand how it works.

For this reason, to explain the process, let’s go back to an earlier day, and describe an imaginary island economy that will illustrate the basic principles of wealth creation.

The Island

Imagine an island populated with industrious and sensible people who are busy producing goods and services for each other. Some grow food, some make clothing, some run stores, build houses, make furniture, and do a hundred and one other important and unimportant things to make life pleasant and satisfying for each other. The time is many years ago. They don’t have electricity, automobiles, or modern technology.

Life for people is more or less the same, year after year. They use the same methods, and equipment, and produce the same output from one year to the next. The housewives spend a lot of time drying and preserving food so there will be something to eat in the winter.

One day a fisherman named Bill Foulke got an idea. He hit on the concept of cooking and preserving his catch in glass jars, instead of selling it fresh every day, or salting it in large barrels. To try out his concept, he built a kitchen where the fish could be cleaned and cooked. He wanted glass jars with close fitting tops.  He got this idea from Helen, his wife, who used to keep leftovers in jars. She boiled the jars so that the food would not spoil.

Finding jars, fortunately, was no problem. Bill lived near to David Livingston, a glassmaker who made window panes, and small glass objects. David had already developed a method of making drinking glasses and jars. He was selling them in a modest way.

Building the fish canning plant was very demanding for Bill. He needed a metal tank for boiling the jars which was difficult to come by in the technology of the day, and glass tops that exactly fit the somewhat irregular jars produced by the glass plant. He and David, the glass maker, experimented for months but could never get the tops to seal tightly. They finally hit on the idea of using gum from a rubber tree to glue them on.

During the many years it took Bill to develop the process, Helen and the children were poorly provided for. While other fishermen were out catching boatloads, Bill stayed home half the time in his workshop, carrying out one failed experiment after another. David Livingston’s family suffered also. The time spent making all those experimental jars and tops kept him from turning out as many glass products for sale as he used to. His family didn’t eat as well, or have as nice clothing as they wanted.

Investing

What Foulke and Livingston were doing was saving and investing in the creation of capital. When they finished their experiments, after many years, they had a process that worked. Foulke set up a little factory that turned out thousands jars of canned fish which soon became sought after all over the island. He hired many people to work in his canning factory. His fish was so popular that soon most of the other fishermen sold the bulk of their catch directly to him. He hired a number of workers to help him in the canning factory. He gave up fishing altogether. Livingston built a special workshop just to make fish jars, leaving the remaining glass business to his two sons, who were old enough to manage it. Livingston hired several people to work in his glass factory.

Both Foulke and Livingston became rich. Their families made up for the years of hardship by ending up among the most prosperous on the island — with new, large houses, the finest horses, and excellent clothing.

Other people gained as well. All over the island, housewives had life a little easier. They didn’t have to spend time drying fish, or soaking salted fish to remove the salt before cooking it. Their families had a better diet. Fishermen prospered, because in this convenient new form there was more demand for fish. Very little of their daily catch spoiled as it used to because they could take it directly to the cannery. The standard of living of just about everyone on the island went up because of this fish cannery.

How investment works

Before he started his process, Bill Foulke supported his family by bringing in an average of forty pounds of fish a day, most of which was sold to the store for about $100. During the years of experimentation, his average daily catch was only about twenty pounds, so Bill’s income went down to $50 a day. All those lean years, then, he was saving his resources (his time, and some materials) and investing about $50 per day in fish canning technology.  David Livingston was doing the same. By the time they had a process that worked, each of them had invested more than $30,000.

What they were doing was saving. Before their experiment, they and their families would have consumed that $30,000 (spent it on consumer goods). Instead they saved it, and invested it in the new process. Once they got the process going, Bill bought raw fish for about $2.50 per pound, and sold canned fish for $5 per pound. Bill’s income went from $100 per day to more than $500 per day. The same thing happened to David Livingston.

Who Gained and Who Lost

So we have two fortunate entrepreneurs whose income has gone from about $20,000 per year to $100,000 per year. Who has lost because of their prosperity?

  • Certainly not the housewives. They are delighted with the new product. Their families are eating more fish which makes them healthier.
  • Certainly not the other fishermen, whose income has gone up as the demand for fish improved.
  • Certainly not the stores who made a profit on each jar of fish sold. They found they could make more money selling canned fish than the raw fish which required them to spend hours every day chipping ice, and days in the winter cutting ice in the pond, and storing it in an ice house.
  • Certainly not the workers who have found jobs in the canning factory and the glass plant, and
  • Certainly not the farmers, who were now asking Bill about canning their meat and vegetables in the same way.

The Division of Labor

But, if no one lost, where did the extra $160,000 earned by Foulke and Livingston come from? This is probably the most important question.  Understanding this point is central to the creation of wealth. The answer has to be “from investment of capital and using it in the division of labor”.  Foulke, Livingston, the employees at their two new plants, and the fishermen, working together with the new capital, turn out more valuable output than any of them could produce by working independently. Ten pounds of cooked fish in the old days might have taken 20 hours of work on the part of the fishermen, the storekeepers, and the housewives. With the new process, the same amount of fish could be served up on the table with less than 2 hours of work expended because everyone is working more efficiently using the new capital in the division of labor. It is from this efficiency that everyone gains, that the extra surplus comes.  Consumers get fish for less than it would have cost them before.  Producers sell their output for more than it cost them to produce it.

The fish cannery and the jar plant are new undertakings that did not exist at all in the old days. Before, the fishermen sold their catch directly to the stores. Now, the structure of production has been lengthened: made more round-about, and in the process, more efficient.  Both the producers and the consumers have gained by the new process.

By consuming less, by saving for three years and by investing that saving, Foulke and Livingston created capital: a fish cannery and a jar making plant. Thereafter, by working with their capital, their productivity and their profits have increased.  Capital accumulation is the royal road to wealth. The entire island is richer because of what these two men did. Everyone’s standard of living has gone up. Everyone is eating better and has a higher real income. Cannery and glass factory employees have new jobs that didn’t exist before.

Indirect Investment

What we have been describing is direct investment.  Livingston and Foulke invested what they could to create their two factories.  Of course, today – as a result of the Industrial Revolution (1760-1830) – we are using indirect investment which is much easier and much more efficient in generating wealth. The process looks like this:

Consumers save part of their income. These savings are placed in some form of intermediary: a bank, an insurance policy, a brokerage firm, etc. The financial intermediary wants to make a profit on the funds placed with them. They seek out profit making opportunities – basically entrepreneurs who are creating products for the market. These entrepreneurs hire workers to do the work. These workers have families who are the consumers.

So, the answer to the question, “How is wealth created?”  is:  “By entrepreneurs using savings and indirect investment.”

Keynesians would not agree with this concept

The principles of wealth creation listed above are so obvious that it seems unnecessary to explain them. However, most economists today would not agree with what you have just read.

Most economists today are Keynesians – that is they follow, believe in, and teach the theories of John Maynard Keynes.  Keynes did not spend much time talking about entrepreneurs. He said that such businessmen were motived by “animal spirits”[i].

Furthermore, Keynes maintained that saving reduces national wealth rather than increasing it.  He illustrated this by explaining the paradox of thrift.  The paradox of thrift is a central component of Keynesian economics, and has formed part of mainstream economics since the late 1940s. The paradox states that if everyone tries to save more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population because of the decrease in consumption and economic growth. The paradox is that total savings may fall when many individuals try to save more. As a result, increases in savings may be harmful to an economy.

Keynesians, as a group, are not inclined to suggest entrepreneurs and indirect investment as a solution to national problems.  Instead they look to government spending and changes in taxes as the main route to solving unemployment.


[i] “Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”   John M Keynes, The General Theory of Employment, Interest and Money, London: Macmillan, 1936, pp. 161-162

About Arthur Middleton Hughes

Arthur is currently Vice President of The Database Marketing Institute based in Fort Lauderdale, FL. Arthur is the author of 11 books, the latest of which is Strategic Database Marketing 4th Edition (McGraw-Hill 2012). A BA graduate of Princeton with an MPA in Economics and Public Affairs, Arthur taught economics at he University of Maryland for 32 years. He is an Austrian Economist.
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