The Individual's Economic Problem

I can't stand this indecision
Married with a lack of vision
Everybody wants to rule the world
--Tears for Fears

Imagine that you have a job cutting wood. Your annual take home pay is $30,000. That $30K is your income. Although you might visualize it as a stack of dollar bills, your income is really a stream of economic resources.

Indeed, before there were dollars and other currencies, your take home pay may very well have been denominated in cords of wood--some fraction of your daily production. Money in currency form merely eases exchange. Rather than trading logs to the baker for loaves of bread, money simplifies the economic calculation of exchange, thereby reducing the awkwardness inherent in trading material resources outright.

As such, it is good to remind yourself every so often that your monetary income really represents a stream of resources.

What to do with these resources? You have two basic options. You can consume them, or you can save them. Consuming them raises your standard of living today. Saving them raises or preserves your standard of living in the future.

The higher the value that you place on living in the present (a.k.a. high time preference), then the more you'll want to consume resources today. If you REALLY want to elevate your present standard of living, then in addition to consuming all of your income, you might seek out lenders willing to let you borrow some of their resources for consumption purposes as well.

The catch with borrowing is that someday you'll have to pay those resources back to the lender plus a little bit extra (a.k.a. interest). If you plan to be more productive chopping wood in the future and your income stream increases commensurately, then borrowing today may not put a dent in your lifestyle down the road. However, should your future income fall short of supporting your elevated lifestyle while paying back the debts you have accumulated, then you will have to dial back on your future standard of living as greater portions of your incoming resource stream are diverted toward paying back your creditors.

The lower the value you place on living in the present (a.k.a. low time preference), then the more you'll sock away resources today for future consumption. This means a lower standard of living now. But those savings could come in handy down the road if/when you a) retire from cutting wood and your income stream vanishes, or b) merely want to supplement your income with saved resources so that you can elevate your standard of living at some future date.

If you save a sizable fraction of your income, then you may be willing to extend it to others in the form of investments that permit other people to elevate their living standards today. You could invest resources in the form of loan projects, in which case you expect to get those resources back in the future plus interest. Or you could invest resources in equity projects, meaning that your resources will be applied toward some productive endeavor that hopefully provides you with a future stream of cash (resources) from the venture's operations. While investing can potentially increase your resource level at some future date, it is also risky. There's a chance that you'll lose part or all of your investment if projects do not pan out. If the perceived reward is high enough, however, it may be worth the risk.

Those resources from savings that are applied toward investment are categorically referred to as capital.

Mathematically, the economic situation facing individuals can be written like this:

income = consumption + savings + investment (capital)  (1)

Another word for consumption is standard of living. If we substitute it into (1) and solve for it, we get:

standard of living = income - savings - investment  (2)

Equation (2) expresses the centrality of income (obtained thru productive work) in determining standard of living. To raise standard of living, you can generate more income. Or you can save and invest less.

You can even raise your living standard thru borrowing (negative savings), altho borrowing to raise living standards today comes out of the hide to future income (to pay back your loans), which jeopardizes your living standard down the road. The more you borrow to live phat today, the greater the chance that your future living standard will be lower.

It's hard to over stress the importance of this basic relationship in understanding our current situation, and the folly of most remedial action either in motion or being discussed.

position in bonds