Prosperity comes from Investments, not Consumption

In the 1700s, when the British started selling Opium to China, it proved to be extremely lucrative. British ships were able to procure opium at extremely cheap prices, and sell them to China at vastly inflated markups. The primary market for this opium was Chinese laborers, who used it to get high and forget the stressors of their daily lives.

It’s hard to imagine any opposition to such trade from most modern schools of economic thought. Free-Trade advocates would find delight in the mutually beneficial trades that were occurring. After all, aren’t all trades mutually beneficial by definition. Supply-siders would take delight in the low taxes that didn’t get in the way of free market activity. And Keynesians would have encouraged the laborers to buy even more Opium, because boosting consumer spending would be advantageous to the Chinese economy.

The Chinese rulers though, saw things very differently. They saw that in order to buy these vast quantities of Opium, the Chinese economy was losing a vast amount of silver. Silver that could have otherwise enriched the nation, and been used for more productive purposes. And what did it get in return? Vast quantities of opiods that put their workers into a drug haze and diminished their motivation and mental capacities.

They saw that this Opium trade was about as mutually beneficial as the trade between a heroin junkie and his dealer. Hence why they opted to ban the use and trade of heroin – only to be forced back into the habit, at gunpoint, by British government-backed drug dealers.

Growing Through Investments

It is this historical backdrop that provides the perfect context for the best theory for economic growth. One that looks past simply boosting spending, cutting taxes and encouraging trade. All mighty fine goals indeed, but still missing one vital piece in the puzzle. A piece that explains why some economic activity, such as drug trade, can be so damaging to some of its participants.

Society’s long-term economic growth, depends not just on the amount of economic activity occurring, but also on the type of economic activity. Specifically, economic activity that is focused on short-term consumption, will lead to worse outcomes. Long term economic growth is maximized when a society’s resources are directed towards activities that produce long-term dividends.

Or to break down into its most simple illustration: If country A is spending most of its money on ferraris and cigarettes, and country B is spending most of its money on education and infrastructure, country B will see greater economic growth in the long run.

“But by buying cigarettes, you boost demand for cigarette factories, which will boost demand for electrical infrastructure, transportation, stimulating numerous other industries, etc etc!”

Yes, but the exact same second-order effects can also be said about infrastructure improvements. Every dollar of infrastructure spending will also generate similar second-order effects. The main difference comes from the first-order effects. Do you wind up with a society where people can efficiently and speedily transport goods from point A to point B? Or a society that has perfected the art of making and marketing cigarettes?


This shouldn’t be a controversial idea. There is an entire economic model built around this premise. A theory that gets frightfully little coverage in the media or mainstream public policy discussions. The Solow-Swan Growth Model.

To put it simply, the model predicts that economic output is governed by three factors:

  1. The size of the labor force
  2. The amount of capital investments
  3. Multifactor productivity, as aided by technology and job training

The size of the labor force is the least malleable of the three, influenced mostly by birth rates and immigration rates. And even then, it has no impact on average income.

Which leaves us with the other two factors – investments made by the society, towards its future. Either directly, in the form of capital investments. Such as roads, railways, power plants and telecom networks. Or indirectly, through education spending, job training, and anything else that boosts labor productivity. Or even more indirectly, through investments in science, that help push the frontiers of our technology.

Notice what is missing however, from the above equation. Consumer spending on luxury goods. Buying cigarettes or veal may have secondary effects on the accumulation of capital stock – after all, cigarette companies do spend money on factories and utilities as well. But these effects are by definition secondary. In terms of helping society build up its capital stock, or improve labor productivity, spending money on beer is no substitute for education funding and infrastructure projects.

Policy Levers

The extent to which a nation’s resources are directed towards investments, as opposed to luxury goods, is heavily determined by the government’s fiscal and monetary policy. Unfortunately, most of the general public’s disposable income, will be spent on luxury goods that do not produce any future returns. Plasma TVs, shiny cars, overseas travel, fine dining etc. In order to depress luxury spending and boost productive investments, there is a significant role for government intervention.

First, providing tax benefits to citizens and corporations to encourage investments. On the corporate side, it could be incentivizing capital investments and R&D spending. And on the personal side, it could be tax incentives for educational expenses, job training, relocation, and perhaps even savings & investments. It’s worth noting that such tax incentives already exist in some form in many countries, but there’s always room to beef them up even further.

Second, imposing significantly higher sales taxes on any and all luxury spending. On transactions such as fine dining, luxury cars, travel, and entertainment.

And lastly, using the proceeds from the above taxes to invest directly in education funding, infrastructure improvements, scientific research, and possibly even sovereign wealth funds.

By using these levers, the nation can minimize spending on luxury goods, and boost aggregate spending on productive investments – both tangible investments like the nation’s infrastructure, as well as intangible investments such as education and job training.

Any Keynesian policy goals, especially of boosting government spending during times of recession, can still be accomplished with the caveat that those government spending must be directed towards projects that produce long-term returns. The Obama era Recovery Act of 2009 is an illustrative example – instead of simply cutting taxes as demanded by the GOP, the Democrats instead opted to stimulate the economy by spending $800B on infrastructure investments and similar projects. The private sector is great in many aspects, but we still need the government to lead the way when it comes to bridges and highways and K-12 education.

Modern Day Success

Just as Qing China was a poster child for the corrosive effects of hedonism, modern day China is a fantastic example of putting the above levers into effective use. On the one hand, the country is home to hundreds of millions of people who are living in poverty – at least by western standards. It would be very tempting for the government to simply cut their taxes and increase their disposable income, so as to improve their quality of life in the short-term. 

And yet, the Chinese government has done precisely the opposite.

By purposely devaluing their currency, the government has encouraged the growth of the local industry and made its exports more competitive – at the cost of its citizens’ disposable income. And instead of returning its massive wealth hoard to its citizens, the government has instead invested trillions of dollars into technology, high speed rail, education, and even overseas investments.

They have consciously prioritized future investments over present-day quality of life. And that is precisely why the country has grown from a third world statistic into a first world juggernaut, within the span of a single generation.

As cliched as it may be, this seems to be a lesson worth repeating in today’s policy discussions. A society that directs its resources towards investments for the future, will see its fortunes rise every year. And a society that directs its resources towards present day consumption, will inevitably find itself on the downswing.