The natural effort of every individual to better his own condition is so powerful that it is alone, and without any assistance, not only capable of carrying on the society to wealth and prosperity, but of surmounting a hundred impertinent obstructions with which the folly of human laws too often encumbers its operations.
Adam Smith An Inquiry into the Nature and Causes
of the Wealth of Nations (1776)
The Situation Before Junior Enters the Labour Force
Recall that before Junior entered into the island’s workforce Company A produced and sold $110 of goods per day. To do so it paid $100 in wages to its workers and a dividend of $10 to its owner. Company A is the only business on Mises Island, it employs all of the island’s workers, there are initially no savings and there is no commercial activity with any other island. On Mises Island, then, daily income (I) equals daily consumption (C). More precisely,
IB + IW = CB + CW
Where IB denotes the Boss’s income; IW denotes the workers’ income; CB denotes the Boss’s consumption and CW denotes the workers’ consumption. Substituting figures into these abstract terms yields
10 + 100 = 10 + 100
110 = 110
We can also depict the situation in terms of a stylised set of “financial statements” (Figure 1). They violate generally-accepted accounting but nonetheless faithfully portray the critical components of economic life on the island. At the end of each day, Company A has $110 of assets, namely the goods that its workers and boss produced during the day. It also has matching liabilities of $110 (the salaries and dividend owed to the workers and boss respectively). Hence - and for ease of exposition ignoring its land and machinery, etc. - Company A has no net assets (i.e., savings or equity) at the end of each business day. First thing each morning, Boss and each worker arrives, is paid the $10 owed to him and exchanges it for goods that were produced the previous day and which will be consumed that day. Each person then spends the day producing the goods and earning the income that will be required the next day, and so on.
Accordingly (and ignoring his ownership of Company A), at the end of each day Boss has generated a personal asset of $10 (the dividend he pays himself) and has a matching liability ($10 of living expenses) and therefore has no savings as a result of the day’s toil. Neither have the workers: each has earned $10 (or a total of $100 for the workers as a whole) and devotes all income to consumption such that there are no savings. On this island income equals consumption and therefore nothing is saved.
Table 1: “Financial Statements” Pre-Junior
“Assets”
“Liabilities”
“Savings” or “Equity”
Company A
$110 (Inventory)
$10 payable to Boss, $100 payable to workers
0
Boss
$10 (Dividend receivable)
$10 (Living Expenses)
0
Workers
$100 (Salary receivable)
$100 (Living Expenses)
0
The Situation After Junior Enters the Workforce
In a couple of respects this situation remains the same on the day that Junior enters the island’s workforce. Most notably, Company A continues to produce $110 of goods; and to do so it continues to pay $100 in wages to its workers and a dividend of $10 to its owner. But in other respects things change dramatically. Most importantly, at the end of the day Boss and each worker saves one-twelfth of his income, i.e., $0.833, such that a total of $9.17 is saved per day. At first glance, it appears that Boss can spend only $9.17 per day (i.e., $10 – $0.83) and the workers can spend only $91.67 (i.e., $100 – $8.33). Let us assume, however, that from his first day in the workforce Junior undertakes successful entrepreneurial activity. He is able, in other words, to find or produce something that is not currently produced but is nonetheless valued by the others. Let us also assume that he is able to sell his daily output for an amount that repays his debt to his creditors. Junior then spends his income of $9.17, derived from the savings of Boss and the workers, on the consumer goods produced by Company A.
On this island, then, income (I) now equals consumption (C) plus savings (S). In the words of Alvin Hansen (A Guide to Keynes, New York, McGraw-Hill, 1953, ASIN: 007026046X), “income in the current period is defined by [John Meynard Keynes] as equal to current investment plus current consumption expenditures. Saving in the current period is, moreover, defined as equal to current income minus current consumption.” Ironically, using one interpretation of Keynes (who was quite confusing and contradictory with respect to this critical point), it not only follows that defined “investment” is necessarily equal to “savings”; “investment” and “savings” must be identical. Hence we have
IB + IW + IJ = CB + CW + CJ + S B+W
Where IJ denotes Junior’s income and CJ denotes Junior’s consumption. Substituting our figures into these terms, and ignoring rounding error, we have
The islanders were astonished, when they examined their “aggregated personal income statistics,” to see that the island’s income has risen from $110 to $119.17 per day, i.e., by 8.3%. Further, as John Stuart Mill and other classical economists realised long ago - but, no thanks to Keynes, contemporary Americans, Australians and Britons have apparently forgotten - income has risen because of, and not despite, the islanders’ exercise of thrift. Employment, too, has increased because of, and not despite, the exercise of thrift. Further, income and employment have increased in proportion to the savings and successful entrepreneurship. Except for the workers’ and Boss’s savings and Junior’s successful entrepreneurial activity, economic activity on the island is unchanged. The savings of Boss and the workers has required that nobody reduce his consumption and has enabled one of their number, Junior, to increase his consumption. Hence this increase of the island’s wealth must logically be attributed to thrift and successful entrepreneurship - and certainly not to politicians’ rhetoric and false promises.
We can also depict the situation in terms of a stylised set of “financial statements” (Figure 2). At the end of each day, Company A has $110 of assets, namely the goods that its workers and boss produced during the day, and matching liabilities of $110 (the salaries and dividend owed to the workers and boss respectively). Hence Company A has no net assets (i.e., savings or equity) at the end of each business day.
Table 2: “Financial Statements” After Junior Enters Workforce
“Incoming”
“Outgoing”
“Savings” or “Equity”
Company A
$110 (Inventory)
$10 payable to Boss, $100 payable to workers
$0.00
Boss
$10 (Dividend)
$0.83 (Loan to Junior)
$9.17 (Payable to goods at Company A)
$0.83
Workers
$9.17
(Loan to Junior)
$91.67 (Payable to goods at Company A)
$8.83
Junior
$0.83 + $8.33
(Proceeds from loan)
$9.17 (Payable to goods at Company A)
$0.00
Similarly (and ignoring his ownership of Company A), at the end of each day the Boss has generated an asset of $10 (the dividend he pays himself), has living expenses of $9.17 and therefore has savings of $0.83. Finally, so too for the workers: each has earned $10 (or a total of $100 for the workers as a whole), has devoted $91.67 to consumption and therefore $8.33 to savings. The island’s total savings of $9.17 (i.e., $0.83 + $8.33) account for the growth of $9.17 of total income (i.e., $110 + $9.17 = $119.17). Accordingly, far from sending the economy into a “deflationary spiral,” as contemporary economists, commentators and others would have it, the act of forbearance by Boss and the workers enables capital formation, entrepreneurship, extra employment and the provision of more goods to occur. Hard work, thrift, sobriety and successful entrepreneurship, then, have led to an expansion of the economic pie on Mises Island such that even a crude (and, in many other contexts, potentially misleading) measure such as aggregate income captures it (see also GNP and Consumer Confidence in Australia: A Dissenting Argument).
