Spending VS Earning

The True Wisdom of Economics: “A dollar spent is a dollar earned.”

Image source: http://www.thetimes.co.uk

One of the earliest economic concepts I learnt during my first ever class of economics is none other than this very idea that spending and earning are pretty much the same thing (i.e. spending = earning) when you look at the broad picture of the whole economy. “That’s crazy!” I thought. Because if it is true, then doesn’t it also imply that I can earn money simply by spending it? How absurd!

Well, to an individual, spending is cash outflow, and earning is cash inflow. That is what logics and practical daily experience have taught us. Indeed, for a person, spending is the exact opposite of earning. Then how can your spending be equal to your earning? That does not sound plausible, does it?

But, let’s rewire the question a little bit. How about “your spending = another person’s earning”? Why not eh? That sounds reasonable. Simply put, the $4 you spend on your daily dose of coffee at Starbucks will be credited to Starbucks’ revenue, to its staff and suppliers. It means that your spending, no matter what you spend it on, is never a waste! Yes, there is always a recipient, and as long as that remains true, the whole economy will be healthy! (let’s assume all else constant at this point). So, remember folks, spending may hurt you, but it helps the others because your expense is their income (or does it really hurt the spenders? because you actually exchange money for goods and services… so this is more like a win-win situation, unless you get ripped off, of course).

This particular way of thinking is also connected to the measurement of the ever popular economic indicator, GDP (Gross Domestic Product). When we look at the economy as a whole, expenditure is equal to income because again, when you spend a dollar, there is always someone else at the other end that receives a dollar. That is why in measuring GDP of a country, to avoid double counting (i.e. adding both expenditure and income of the whole country together, which can severely distort the result by doubling the amount of the actual GDP), what they do is looking at just one side, either the income side or the expenditure side, NOT BOTH.

The simple, yet profound, concept of spending and earning is the core of “Paradox of Thrift”, the notion that if people spend less during economic downturn, the lower spending (and more saving due to fear of recession) will lead to lower aggregate demand, lower income, and in the end, only serve to worsen the economic situation. This can also all be explained by “Circular Flow” a model that depicts the flow of money within an economy. In its simplest form, circular flow is the back and forth flow of income between houesdholds and firms. Households receive income in the form of wages from firms, and then, the households’ income becomes the firms’ income as the households use their money to purchase goods and services back from the firms. I guess you can see the picture here. That is why the more households save, the less they spend, the less is left in the circulation, which is collectively harmful and can result in negative economic growth for everyone.

These very ideas gave rise to the world renown Keynesian economics. John Maynard Keynes, the father of the dubbed modern economics. Keynes was a man of extraordinarily keen sight; he noticed that the decline in aggregate expenditure would severely hurt the economy because as expenditure plunges, income also falls (because expenditure = income). So, during the great economic depression in the 1930s, Keynes was very critical of the British government who was too timid to act and kept cutting back spending. In his book, Keynes advised the government to pump out spending (run deficit) so to keep the circular flow of wealth (spending -> income -> spending -> income…) going. This is called expansionary fiscal policy, through which the government spends more and/or taxes less. Once the government increases its spending, the business world will be able to rebound back on its feet, employment will rise, and people will be able to once again earn enough to spend to sustain their livelihood. We can see that the little spending spark created by the government will make it possible to fix the stalled economic engine. And that is the rationale behind the practice of keynesian economics.

In a nutshell, spending is just as vital to the economy as earning. Even a broken window that forces you to call the glass repairman is not such a bad thing for the economy. I mean if everyone’s windows are damage-proof, then we will lose a section of the job market (no window repairman since they have nothing to do!).

Of course, I am simplifying the concept as much as possible so that it is easy for you, the reader, to digest. Things aren’t that simple. Theory is not perfect, and this one is no exception. In fact, there are loads of criticism deriding what I have just explained to you, but it is better to learn step by step.

Next time, we will introduce an add-on to this topic. We will look at the forgotten side of the story by including new variables, make it a little bit more complicated for those seeking challenges.