Basic economics courses often use the example of Robinson Crusoe stranded on a deserted tropical island. This is to show that even in the case of one person, economic principles still work. These principles are so fundamental that they ought to part of everybody’s basic knowledge. Here goes.
Having just stranded on the island, Robinson starts plucking berries. He can pluck 10 berries each hour and he needs 80 berries a day to stay alive.
Robinson must work at least 8 hours or he will starve. The reason is that 8 hours results in 80 berries which he must eat.
Now, having plucked berries for 8 hours in a row, Robinson can choose to take the rest of the day off or he can choose to keep working. Suppose he works 10 hours. That way he has 100 berries. Now he could eat them all and gain weight or he could save 20 for tomorrow.
If he saves 20 berries each day he will save 80 berries in four days. Those eighty berries are his savings. If he is wise he will keep these berries as an emergency fund. If he gets sick, he won’t starve. If he did not have an emergency fund, he would be in dire straits any time something unexpected happened.
There are two rules here.
First, earn more than you spend, e.g. pluck more berries than you eat.
Second, save enough for emergencies.
Now assume that Robinson thinks that he will only get sick for a maximum of one day. Keeping up his routine of plucking 100 berries and eating 80, he will keep saving 20%. After another four days, he will have a) one day of emergency savings b) one day of extra savings.
Robinson now has two choices.
a) He can take a day off.
b) He can spend a day making a berry plucking stick that can reach berries on the higher branches.
Observation: If you have savings, you have choices.
If he takes the day off, he can enjoy a nice day at the beach. However, he can also fashion a stick that allows him to pluck 15 berries an hour.
If he chooses b), we would say that he invests his 80 berries to get a berry plucking stick.
Now he can choose to work 10 hours a day and pluck 150 berries or he can do 8 hours and pluck 120. Let’s just say, he keeps working 10 hours a day. His income (in berries) has increased 50% due to his choice of making the stick rather than hanging out at the beach.
There is one additional rule here:
Third, don’t spend all your money (berries) on leisure, but invest some of it to increase income in the long run. Of course here, Robinson invested all his savings. Something which I of course heartily recommend.
After a while having built a few sticks, Robinson is practically drowning in berries. Now he could start working on 6 hours a day. After all with a stick, 6 hours gives 90 berries which is enough to sustain him. He could however work 8 hours a day, build up a few days of savings and spend some time inventing a fishing pole. Having a fishing pole would allow him to catch and eat fish and increase his standard of living.
Let’s say that Robinson keeps working hard and eventually invents fire, a little hut, and bow and arrow. He now lives nicely but still has to work a few hours a day.
The important point to note here is that Robinson spent his initial savings on investments to increase his long term standard of living. If he had eating all his berries in the beginning by either working less hard or taking time off, he would still be working 8 hours a day and eating nothing but berries.
Of course in this day and age things work a little differently. We use money instead of berries and in many cases, we don’t invest directly in our own inventions, rather we hand our money over to a company by buying shares and the company then invests in assets (sticks), takes a cut, and hands us back the surplus, but the principle is the same. Saving and investing is the key to prosperity.
Now lets deal with debt. Debt may or may not lead to prosperity. While it is hard to dispute that saving and investing leads to prosperity the result of going into debt is dependent on what the debt is used for as I’ll show below. Now, in order to have debt, we need another person – for every debtor there must be a creditor. Staying with the Crusoe universe, let’s call the debtor Friday.
Initially Friday is plucking berries like Robinson did in the beginning. Friday sees that Robinson uses a stick to pluck berries and Friday would like a stick of his own. Now Friday could spend four days saving up to make his own stick. Remember, the cost of a stick is one day’s worth of berries or 80 berries. Friday asks Robinson if he can borrow 80 berries and pay them back next week. Sure says Robinson, but if I lend you 80 berries today, I want 160 berries next week. The reason is that Robinson could eat the 80 berries himself and spend his time working on something that would earn him 160 berries over the next week. Friday thinks it over:
Alternative 1: Spend 4 days savings 20 berries a day. Take day 5 off and make a stick. Pluck 150 berries on day 6. Surplus: 150-80 (eaten) = 70 berries.
Alternative 2: Borrow 80 berries today and make a stick. Earn 150 berries and eat 80 of them leaving 70 on days 2-6 for a total surplus of 350 berries and pay Robinson back the 160 as promised leaving 190 berries.
Alternative 2 seems like the wiser choice since it results in 190 berries after a week rather than 70 berries. So let’s say Friday agrees to pay Robinson 80 berries in interest (100% per week, pretty high!). This is an example of when incurring debt can be a good thing. However, what would happen is Friday who has not even built an emergency fund would get sick tomorrow. He would still be on the hook for the 160 next week, but he would have no time to build his stick. Even working every day, he would only have 120 berries which is not enough. Friday would be insolvent and default on his debt. (This is why people in debt need disability insurance, The Affleck commercials , which you’ve probably seen, describe the situation pretty well.).
The rule here is:
Fourth: Debt comes with risk, but can be used to boost future income if invested properly. In fact most companies use some form of debt to boost their earnings. Students also use debt to get an education to boost their future earnings.
Of course debt can also be used unproductively. Suppose Friday desires a shelter or a day off instead. It normally takes a week to build a shelter, but Robinson is willing to lend the money now for weekly installments for the next 6 months. I wont be writing down amounts in berries anymore, but it should be clear what is going on here. Robinson is foregoing productivity in return for an extra income (interest) which Friday is now on the hook for. Friday in turn needs to spend future income for his present consumption (the hut). In other words Friday will be paying more than he would if he saved and paid in cash, in return he gets the hut now. The money he has to pay Robinson in interest will not be used to invest in increasing Friday’s future income. Rather it is used to increase his present standard of living despite him not having earned the money to pay for it yet.
However, at least Friday will have a shelter to show for it which he could sell back to Robinson should he choose to do so.
Suppose however that Friday borrowed to increase his present leisure such as a game system. Then he is truly on the hook. He still has the interest payments, but he will not have a higher income because he did not spend the money (berries) on a stick or a fishing pole or an education. He does in fact have nothing to show for his debt.
Robinson on the other hand will have a stream of income. If that stream of income gets sufficiently large, Friday will essentially be working part time for Robinson to service his debt. Remember, that Robinson could not stop working when he was the sole survivor on the island. (We will forego the point of inventing robotics). He needs a system of wealth transfer through debt to stop working. With Friday in debt, Friday can’t stop working for Robinson.
Now the question is, which would you rather be? Robinson or Friday? You make this choice every time you handle money. Do you save it? Do you invest it? Do you borrow it?
It is really as simple as that. The rest is just details. Presuming that you really want to be like Robinson, the first thing to do is to work hard and save some money. The second thing to do is to establish an emergency fund. The third thing to do is to invest. The fourth thing is to get wealthy. The fifth thing is to generate income streams. And the sixth thing to do is to retire and spend every day on the beach. You can’t do six before you did five. You can’t do five before four, and so on. Everything starts with making more money than you spend. Without that, everything else is void.
I have not mentioned debt in the six steps. The reason is that debt is a sophisticated way towards becoming wealthy. It is not strictly required (I didn’t use it). Debt should in my opinion never be seen as an opportunity for consumption. It can sink your financial ship very quickly! Anyway, let’s see how debt work in hour society. It is almost taken for granted now that big items are financed with debt. Rarely do we negotiate the cash price, we negotiate the monthly payment. This goes for houses and cars. It is increasingly the case for things like furniture, and electronics and of course with credit cards it can be the case for everything. The way it is set up is as follows. Robinson knows that Friday can pluck 100 berries in a day out of which he will have a 20 berry surplus. This means that Friday can pay 20 berries in debt service a day. If the interest is 2%/day (to make it simple), Friday can borrow 1000 berries because 2% of 1000 is 20 which is what Friday can produce. With that Friday can get a hut, a new set of clothes, and a nice boat. However, having maxed out his repayment capacity, Friday is now effectively indentured to Robinson. That is to say he is effectively a slave of his own debt. It will be very hard to get out of this debt because a) he does not have any money left to invest to raise his income (e.g. getting a stick) b) even if he worked an hour more each day it still would take a long time to pay of the equivalent of a 1000 berries. This illustrates why unnecessary consumer credit is never a good idea. The best solution here is of course not to fall for the initial temptation of what is apparently free money.
This is essentially how the world hangs together. Of course most of us have some savings, some investments, and some debt all at the same time. What makes some people rich and some people poor is due to the different choices we make when it comes to working, saving, spending, investing and getting into debt.
Originally posted 2007-12-30 09:28:32.
