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When I worked at the engineering company back in the 1970s, we had just acquired a master planning project with PT Krakatau Steel, an Indonesian company, to help set up a new steel mill in the middle of the jungle. The contract had originally been awarded to the Soviets, but they had apparently muffed it. One of the stories I heard at the time would help explain why.
Any industrial complex starting from the ground up in a remote location involves a lot more to be planned, designed, and built than just the core facilities. In addition to the steel furnaces, rolling mill, and probably a coking plant, you have to build transportation by road and rail to the site, warehousing for both incoming construction materials and eventually for the mill’s raw materials and outgoing product, housing for construction workers and later for plant operators and administrators, and usually some form of supporting community with a water supply and a power plant. It was the latter that had gotten the Soviets into trouble. At some point midway through the planning process—and long before they had any need of it—the Soviet team heard that Hitachi in Japan had taken return on a turbine-generator unit from another customer and were offering it for sale at a reduced price, say, sixty or seventy percent of the original purchase price.
The Soviet planners, thinking they were making a wonderful deal with significant cost savings on behalf of their Indonesian client, bought the generator and had it shipped to the site. This was, of course, several years before ground for the power plant had actually been broken. But the Soviets probably thought that was a good thing, because they could then modify the steam system design to meet the turbine’s established specs, which were already close to the project requirements. And shipping the unit to the site immediately saved them the cost of warehousing it somewhere else, probably back with Hitachi in Japan. So the purchase looked like a smart deal from several angles.
What they found in practice was a whole other matter. First, a turbine-generator for an industrial-scale power plant is a huge beast, at least the size of a boxcar if not a large house. But it’s also a delicate beast. The turbine wheels and blades are precisely designed, machined, and assembled for each stage of expansion and cooling as the high-pressure steam passes from one wheel to the next. The shaft turns on glass-smooth bearings so that just a whisper of steam will start it moving and keep it turning. The generator is wrapped with miles of copper wire to develop the electro-magnetic current, and the rotor and stator move on more bearings so that the magnet surfaces almost make contact within precise tolerances. The whole thing ships inside a huge crate made of strong wooden beams lapped with high-quality plywood.
When you ship this beast into the center of the jungle and lay it down on a patch of shaved dirt, without the proper inspection, security, and environmental controls found in any competent warehouse, you invite calamity. Moisture, corrosion, insects, and other surprises arrive to attack those delicately machine parts. Local residents face the terrible dilemma of either watching all that free, top-quality lumber just sit there or taking it for their next housing project when no one is looking. Within six months to a year, and long before it was supposed to be installed during construction, the Hitachi turbine-generator was sitting naked in the jungle and rapidly corroding into a dead lump of steel and copper worth nothing to anyone.
Any competent mechanical engineer might have foreseen this physical deterioration. Rather than ship the generator to the site ahead of time, the Soviets should have factored into their purchase decision the cost of warehousing the unit with Hitachi or a third party for several years. This would have shown how much real saving, in terms of all their projected costs, that sixty or seventy percent reduction in price actually represented.
But even this level of sophistication would still be thinking like a Soviet—which means thinking like an economic child of the 19th century.
As good Marxist-Leninists, the Soviet planning team had only one standard of economic value: the labor input to make the generator unit. Hitachi’s Japanese engineers had labored and been paid to design the machine. Their machinists had been paid for their effort in shaping the steel, assembling the turbine, and winding the generator’s copper core. And at some earlier point, miners digging copper ore in Africa and iron ore in Australia had been compensated by Hitachi when the conglomerate paid the price of those raw materials. The Soviets figured they were merely trading a certain number of rubles, or their Indonesian client’s rupiahs, to cover all this embedded labor cost. And that value chain in labor represented the sum of the transaction: the turbine-generator had a fixed cost based on the labor inputs, and if Hitachi was willing to sell it at a reduced price and eat the difference—because some previous customer had ordered the unit but didn’t need it anymore—well, that was just bad luck for the foolish capitalists who ran Hitachi! In the Soviet view, the generator itself had only static value, unchanging no matter when it was made, when the project planners needed it at the site, or what they might have done with the money in the meantime.
The American planners at my engineering company, capitalists that they were, could have told you in about six seconds that the Hitachi turbine-generator was a bad deal at almost any price reduction. They laughed at the Soviets for thinking that snapping it up was a such a lucky opportunity.
My engineering company routinely ran a sophisticated computer program1 that correlated a project’s schedule with the estimated cost of all materials and equipment, labor costs in each skill category, logistics and shipping costs, and current financial factors like interest rates, inflation, and the relevant currency exchange. The schedule program was based on a Gantt chart—a type of bar chart developed a century ago but still the basis of almost all project software—which breaks the whole effort down into separate work packages and puts them in the correct sequential order. So, for example, you know that you have to complete the site grading and excavation before you can lay rebar for the foundation, and you must complete the rebar installation before you can pour the concrete around and over it. This means the steel rebar itself must be purchased and moved to the site a certain number of days before the excavation period ends, in order for the task of cutting and bending, then laying and tying the bars, to begin on time.
The Gantt chart can be a massive piece of work, accounting for every contract, material, and work package on a project.2 And the chart itself is not a static object which you write up once, before breaking ground on the job, and then just follow along and check off boxes. Instead, the chart is a living image of the project itself over time. So, for example, if your supplier is late delivering the rebar, you note that, and the chart automatically adjusts the dates and deliveries for all dependent work packages downstream in time. Or a really sophisticated Gantt program may offer adjustments that you can accept in your basic assumptions and task planning to make up for the delay. Each work package also includes a “slack” or “float” period, built in at the task’s beginning and end. These periods show the amount of time by which each step’s start or finish date can be delayed without delaying the next step or the overall project’s completion date. The float provides flexibility in both planning and execution.
With this scheduling capability in hand, and knowing what your estimated costs are for each task in the project, what kind of cash flow you will need to complete that task on time, and what your next planned expenditures are in order—plus what the interest rate or the cost of that money is, the inflation rate that will eat away at any money you hold onto too long, and how currency exchange on an international project is shifting those relative values day to day—you can pretty well plan for a least-cost, maximum-value project turnaround.
Such a planning and estimating computer program—accounting for all aspects of the project, not just the labor value of component parts, materials, and construction effort—would have told the Soviets that even knocking thirty or forty percent off the generator’s purchase price wouldn’t make up for the cost of borrowing the money so far ahead of time and paying interest on it for a couple of years. That’s why big pieces of equipment are called “capital goods.” They represent an investment in money that must be borrowed up front3 and paid for with interest. You balance the cost of that money with its purchasing power today, what inflation will do to that value tomorrow, and what sort of return on investment the purchased part will contribute to your financial situation once it goes into service.
The capital good stands in place of all the other uses to which that money might be put and the increase in value over its own cost it will eventually produce. These are collectively called “opportunity costs” versus “sunk costs” under the rubric of the “time value of money.” In this frame of reference, sinking a big wad of expensive money into a turbine-generator that will sit idle for a couple of years—even before the project can start installing it and hooking it up to make electricity, and long before the completed steel mill actually needs that electricity—well, that’s just stupid. And it’s stupid even before taking into account that the precisely machined and intricately balanced turbine and its lovely wooden crating will rot in the jungle and turn into junk.
What separates the late 20th and early 21st centuries in the Western world from every other place and time in history is the sophistication of our mathematical and conceptual tools. These are often simple equations involving present value, future value, expected time periods, and projected interest rate. You can solve them with a stick in the sand, as Pythagoras might have. But the other distinction we have is fast computer processing power linked to sophisticated programming which lets us chain these equations together and compare multiple cases at one time dealing with many slippery, sliding, and competing variables. But before the computer programs can do their work, you must have the concepts.
We are no longer sending thousands of people out with picks and pry bars to spend the next twenty years cutting a million limestone blocks out of a quarry and stacking them up into a pyramid, all to just sit there and honor the vanity of a dead pharaoh. When we build something in the modern world, it has to work, have purpose, and create value. The money we spend on a project represents both that money’s initial purchasing power, the time and cost associated with building or waiting, and the potential return to be made on all potentially competing projects. Analysis of all these factors allows us, as a society, to weigh correctly the choice of building, say, a dam to provide hydroelectric power and a stable water supply, or a thousand miles of new railroad track to move goods, or a new runway at the local airport to move people into and out of the region, or a new office building to provide those people with a place to work.
We in the West don’t spend money and build projects or buy goods because of a politician’s whim or vanity, or because it seems like a good idea at the time, or because we can make a killing on someone else’s turbine deal that went south. We know when and what to build because we have conceptual tools—plus the judgment and self-restraint to use them—that underpin a modern and sophisticated view of economics. By comparison, cultures and societies that view money as a fixed commodity, or a simple exchange of labor for purchasing power, will always be on the outside and lagging behind the Western world. They will build the wrong things, in the wrong amounts, at the wrong time—a deadly error in a fast-moving world. Just ask the Chinese about all those apartments in the desert.
Money is not gold coins or any kind of object. Money is a form of energy, a dynamic thing, like electric current in a wire or the flow of water in a pipe. Money is not a byproduct of labor but an input all its own.4 In use, it acquires force and multiplies its energy, just as a thrown baseball has more apparent mass on impact than one that’s just sitting on the ground. It is our appreciation of this effect, captured in our conceptual tools, that has made Western civilization different from any that has come before. We’ve been developing new ideas about money and its uses since the Italian bankers of the 15th century. So we are now about five or six centuries ahead of everybody else and their antique concepts.
The rest of the world thinks we just have more money. What they don’t understand is we have more and better ideas!
1. This was back in the days when the computer was an IBM 370 in the basement. Today you could run this sort of software on your laptop or even your smartphone. The company considered this planning and estimating software to be their own proprietary invention, but that just meant the planning department experts had written their own program code. The principles were commonly known and widely practiced throughout the construction industry in the Western world.
2. The Gantt chart, if managed properly, will tell you how many toilet bowls are planned for the restrooms in the administration building—along with all the plumbing fittings and knobs on the stall doors. It will also tell you who has bid to supply them, what they will cost, what the lead time is for purchase and delivery, when they were ordered, when they are due to arrive on site, when they did arrive, and how many workers will be needed to install them in the time allowed on the schedule. Running a Gantt chart means you take nothing for granted.
3. Nobody these days starts a long-term project by saving up ahead of time and then paying out cash from his checking account for each material purchase and contract payment. Yes, you can earn some interest on your savings, but you must also watch the purchasing power of your money erode with inflation. In the real world, you finance step by step and watch the sliding interest and inflation rates carefully.
This raises the question of why, right now, we aren’t seeing a massive outpouring of construction projects for new manufacturing and infrastructure, given that the interest cost of money is near zero and the eroding power of inflation is also vastly muted. For one thing, banks have no incentive to lend when the money won’t earn a payback. For another, businesses that have money would rather spend it buying back their own stock and reducing their liabilities than on increasing their holdings and indebtedness to create productive capacity they’re not sure they’ll need. This time of zero interest and near-zero inflation feels eerie, like the eye of a hurricane after the financial buffeting we’ve all been through in the last couple of decades. And everyone is wondering what the other side of this dead zone is going to bring.
4. See The Economy as an Ecology from November 14, 2011.