What makes up an economy
05 February 2016
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Chris Gibbons: Welcome to the latest edition of Old Mutual Live Business, we are bombarded day in and day out with financial and business information and entire TV stations are given over to nothing but. Clearly there are experts who understand every single nuance. But how do we approach this in layman’s terms? What are the factors that go to make up this thing called ‘an economy’.
What role is played in an economy by business, by government, by consumers? Well, to bring some clarity to this, we’re joined now by Professor Adrian Saville. Professor of Economics and Finance at GIBS, also Chief Strategist at Citadel Asset Management. Adrian, welcome to Old Mutual Live Business, this is really is economics 101, what makes up an economy?
Four main factors of an economy
Adrian Saville: Chris, thanks for having me on the show. The essential ingredients of a modern economy can be described by four main factors. The first thing is the one that you and I most easily associate with and that’s household spending or what’s also known as consumer spending.
You can think of this as everything from spending on school fees through to spending on food and spending on holidays. The first component is household expenditure, consumer spending. The second component is what comes from the private sector in the form of investment spending.
That takes the shape of the building of factories, the construction of mines, anything that is associated with investment by the private sector in building productive capacity. The third component, you made reference to it in your introduction, is government, which is an important part, a large part of all modern economies. Government spending takes the form of spending on public servant’s salary or civil servants salaries all the way through to the spending on the construction of highways or telecommunications infrastructure.
Those three components are usually referred to as the domestic components of the economy. They are South African based, South African resident, they’re inside of the borders of the country. So the households, investment spending and government spending.
The fourth component is referred to as the foreign sector and the foreign sector represents what South Africans can sell to the rest of the world in the form of export activity. That export activity, certainly if you have a South African mindset, that export activity would take the shape of exporting fruit, exporting wine, exporting raw materials like iron ore, coal, gold or platinum.
If selling things to others contributes to the economy, then buying things from others represents a leakage from the economy. In that foreign sector, whilst we add what we export to others, we have to take away what we import from others. If we were buying vehicles from Germany or coffee from Brazil, those imports would be taken out from the economy.
South Africa is a commodities exporting economy
CG: If we break it down Adrian, a little bit further, we hear that this country is a manufacturing economy, that country is resources based. South Africa, you tell me a case in point, we are a commodities exporting economy.
AS: Yes, you know, interestingly, the mining sector makes up less than 10% of the economy. But because the mining sector has so many spill overs and linkages to other parts of the economy, that it results in this relatively small sector in its physical activity through this many influences.
Through these many linkages, it results in South Africa being heavily influenced by the commodity sector and a rule of thumb that will help you get a sense of just how important commodities are to the South African economy is; every 10% change in commodity prices will influence economic growth in South Africa by 1%.
In other words, if commodity prices go up by 10%, South African economic growth goes up by 1%. If commodity prices fall by 10%, South African growth goes down by 1%. That makes the South African economy very sensitive to commodity prices. I mentioned some of them before, in particular, the likes of platinum, iron ore, coal and gold.
CG: If we look at the three key domestic actors, if I can call them that, that you mentioned, if we start with business, surely if there’s no business, there’s no economy?
Does business drive economies?
AS: I think that that’s a fair point of departure, is to recognise that economy is a hinge on investment spending. Investment spending is made, generally, in the first instance, it’s made by the private sector, by businesses. That investment spending will take the form of the construction of plant factories, the opening of mines and so on.
But it’s not only the business that can take responsibility for investing, the public sector or government is also an important investor. In, to use South African examples of recent important government expenditure or public sector expenditure, you can think of the likes of the Eskom Power Plants, Medupi and Kusile.
You could also think of the highway extension programmes or the constructional renovation of airports, the laying of fibre optic cable, many of these are public sector responsibilities. I think there’s, you know, really two points to make.
The first is that it’s investment spending that is the engine of productive capacity of the modern economy. The private sector generally is responsible for the bulk of investment spending, but the public sector is a very important co-investor. Often making investments that facilitate or give capability to the private sector to then make their own investments. In other words, the two need to be partnered.
CG: Government also has a critical role to play, correct me if I’m wrong, in that it creates policy. Which not only effects how it behaves, but also how business behaves.
Government policy has an impact on an economy
AS: Yes, and being trained in economics, you know, one of the larger areas of interest is which policies work best and here you can think of some of the more famous or fabled names in economics. That span from the likes of Adam Smith all the way through to Karl Marx.
Adam Smith says: what you want for an economy to work well, is you want government to stay out of the way. What became known as a free market approach or a Les Affaires approach, to use the French term. Les Affaires basically says: hands off, guiding the government to step out of the way, take their hands off the economy and let the private sector get on with the business of business.
At the other extreme you have the Marxists who say government needs to step in, that you need a central planner who is able to guide and direct and shape the economy. There’s a furious debate that spans over, not decades, but hundreds of years between these competing schools of thought as to which approach is the best to facilitate economic improvement and social advance.
Interestingly, in the work that we’ve done in trying to understand the importance of policy, what we find is what matters much more than the policy is policy stability. In other words, as long as you establish stable rules of the game, then economic actors are able to take those rules of the game and play the game using those rules to guide their decisions. In short, what economic actors need is certainty.
An economy planning for the future
CG: Is it possible, Adrian, to change an economy? Eventually South Africa’s mineral resources will run out, I suppose, so we’ll have to do something different, is it possible to start changing your economic base now?
AS: Absolutely and this is what we refer to as structural transformation. Most economies, all economies start in the first instance, doing something basic. If you think of where the United States was or Western Europe were initially. They were basically agricultural economies with some mining activity.
You might think of the British coal mines or in north America, the prairies, growing grains and wheat. So all these economies have their origin in what’s known as the primary sector. As skill and capability and knowledge develops, then economies become increasingly sophisticated.
So, you might start with sheep and the sheep then becomes an input into wool and wool becomes an input into a garment factory and the garment factory becomes an input into a sophisticated retailer and that sophisticated retailer then needs marketing or advertising services and this then gives you a sense of how an economy shifts. From being a basic agricultural economy through to a sophisticated services economy.
CG: For that explanation into what drives an economy, how an economy works, Professor Adrian Saville, thank you for being with me on Old Mutual Live Business.