Four Economic Activities and the Wealth of Nations

Economic growth
Macroeconomics - Economic growth - Monetary Policy

This article is a telegraphic summary of the 2022 book “Why and How humans trade, predict, aggregate, and innovate. An Economist’s Lessons on the Role of Human Behavior and Economic Systems" (ed. Springer).

Trading, forecasting, aggregating, and innovating - referred to from here on out as the ‘Four’ - are activities that people have engaged in since the beginning of our race. They are part of the human fabric because they stem from mankind’s peculiarities—heterogeneity, inclination to forecast, sociality, and inventiveness. The Four are key social interactions in human life at both the individual and aggregate levels.

In 2019, the value of worldwide global exports amounted to approximately US $19 trillion. The majority of humans live together in urban areas, while an even larger share belongs to social groups such as families and firms. Virtually everyone, finally, has very often to deal with forecasts and innovations. In a nutshell, the Four are ancestral, vital social interactions that each of us face not in only special moments but, rather, every day.

Why do humans perform the Four? Because each of them has some peculiar gain. While it is easy to recognize the paramount role of innovating activities for both the individual well-being and systemwide performances, some words on the other three affairs seem necessary.

The division of labor allows specialization hence higher productivity. But it needs the exchange of what each produces. To the extent that trading is a free choice between partners with the same bargaining power, it improves the condition of all participants (otherwise, why choose to trade?). Robinson Crusoe’s story puts forward the idea of the gains from trade. Centuries ago, Venice (a small city, after all) became an economic superpower, exploiting its commercial connections that made up the Silk Road network. Another way to appreciate the advantages of the exchange is to consider that sanctions banning trading activities are aimed to inflict damages to sanctioned countries. Iran, Russia and North Korea are case history. Brexit is an instance of self-inflicted damage—4% of the GDP will be lost in the long run according to the Office for Budget Responsibility.

One way to see the gain from forecasting is considering when expectations are wrong. At the individual level, if someone figures out that she has no chance of finding a job (becoming a ‘discouraged worker’), then she will not adequately prepare herself for the job market and/or will be apathetic in her job search. This forecast-induced behavior may magnify the likelihood that grim expectations – and real losses - will materialize. Alongside discouraged workers, poor people may as well get trapped in a permanent state of poverty because their own gloomy predictions to improve steer them to be insufficiently proactive. If employees/lenders earn fixed wages/interests, then, underestimating price developments in high-inflation environments would lead them to lose significant purchasing power. Clearly, these individual situations may be so widespread as to affect the economy as a whole. Looking more explicitly at the aggregate level, the gain from correctly forecasting emerges in maintaining stability in the system. Expectations should not diverge too much and/or for too long from fundamentals. In financial markets, for instance, the price of a stock or a sectoral index must reflect the fundamental value of the firm or that sector. Bubbles such as the and the 2008 subprime mortgage crises are points in case. As well known, financial crises often distress the real part of the system determining huge socioeconomic costs. One may then think about intertemporal decisions. These must be such that aggregate demand is not systematically larger than the system-wide fundamental, or natural, capacity of production. Otherwise, again, the system dangerously overdrives.

Since the outset of our species humans have been well aware that unity is strength and that there are gains from aggregating. We form several clusters—families, clans, villages, cities, up to the United Nations. For the present aim, cities and firms are particularly critical social aggregations. Aggregating in a city enhances labor division and specialization and, accordingly, productivity and wages, as the so-called ‘urban wage gap’ indicates. Cities then have the advantage of the critical mass. The quality and quantity of goods and services available in a big city is much larger than what one can find in a village. Only large cities can afford to sustain the demand for niche products and/or the high fixed costs of cultural activities such as theater, museums, and the like. Typically, neither congestion nor high housing prices convince people to abandon their urban location. Humans concocted the firm once family and trading became insufficient for their insatiability. R. Coase argued that humans aggregate in firms because of transaction costs, i.e., the costs and time of creating and maintaining property rights, opening a firm, finding suppliers and customers, etc. Within a firm, all these costly activities can be easily managed with virtually no negotiations/costs.

Although the Four have a dark side, they can reinforce each other and their gains sum up, boosting mankind toward big achievements. A prominent instance is the Industrial Revolution started in the 1800s (cf. Fig. 1).

During the Industrial Revolution, all the Four were sustained pushing economic systems to be increasingly innovative, urbanized, and exchange-oriented in a globalized way (forecasting has connections with all the other three activities). They let humans to escape from the Malthusian trap. In 1800s there was a strong acceleration of patents and patentable inventions per person. A set of innovating businesses were quickly emerging and diffusing across firms.

Cities and productive firms escorted innovating efforts. Geographical aggregation materialized because most of the innovations required that machinery be centrally located where sources of power were available. Innovating allowed production to become massive and it was increasingly located in factories. Firms increasingly featured the economic landscape. The mechanization of production made necessary urbanization. If until 1800 more than 90% of the population of all nations lived in rural areas, in 1900 almost half of the inhabitants were urbanized in western countries. Innovating and trading were tightly intertwined, too. Most of the innovations of the period popped up because of the presence of large trading markets. Industries such as cotton and pottery would not have grown to a large scale without the existing system of intercontinental seaborne trade relations. The innovative products of the British Industrial Revolution quickly invaded foreign markets, reshaping international trade. At the national level, the period witnessed innovations in the way of trading. Marketing and advertising are points in case. If until 1800 there was a long period characterized by persistently low international trade - with the ratio of total trade, exports plus imports, to global GDP never exceeding 10% - then this ratio quickly tripled, reaching 30% just before the WWI. It should be clear that forecasting has tight connections with all the other three activities. As per the Industrial Revolution, in a sense, it may have also induced different forecasting attitudes. When, as shown in Fig. 1, things tend to move slowly for long periods, one is tempted to give great weight to the past when imagining the future (Malthus docet). But when dynamics are bubbling, when the present is so different from the past, then inertia and experience contribute less to forecasting. The Industrial Revolution may have made humans more forward-looking than ever. The contribution of forecasting may also be somewhat inferred from the fact that, as observed, sustained system-wide growth cannot coexist with systematic system-wide prediction errors.

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