Basic Economics

by Thomas Sowell

  Such institutions took centuries to develop in the West. Nineteenth-century London was the greatest financial capital in the world, but there were earlier centuries when the British were so little versed in the complexities of finance that they were dependent on foreigners to run their financial institutions—notably Lombards and Jews. That is why there is a Lombard Street in London’s financial district today and another street there named Old Jewry. Not only some Third World countries, but also some countries in the former Communist bloc of nations in Eastern Europe, have yet to develop the kinds of sophisticated financial institutions which promote economic development. They may now have capitalism, but they have not yet developed the financial institutions that would mobilize capital on a scale found in Western European countries and their overseas offshoots, such as the United States.

  It is not that the wealth is not there in less developed economies. The problem is that their wealth cannot be collected from innumerable small sources, concentrated, and then allocated in large amounts to particular entrepreneurs, without financial institutions equal to the complex task of evaluating risks, markets, and rates of return.

  In recent years, American banks and banks from Western Europe have gone into Eastern Europe to fill the vacuum. As of 2005, 70 percent of the assets in Poland’s banking system were controlled by foreign banks, as were more than 80 percent of the banking assets in Bulgaria. Still, these countries lagged behind other Western nations in the use of such things as credit cards or even bank accounts. Only one-third of Poles had a bank account and only two percent of purchases in Poland were made with credit cards.{439}

  The complexity of financial institutions means that relatively few people are likely to understand them—which makes them vulnerable politically to critics who can depict their activities as sinister. Where those who have the expertise to operate such institutions are either foreigners or domestic minorities, they are especially vulnerable. Money-lenders have seldom been popular and terms like “Shylock” or even “speculator” are not terms of endearment. Many unthinking people in many countries and many periods of history have regarded financial activities as not “really” contributing anything to the economy, and have regarded the people who engage in such financial activities as mere parasites.

  This was especially so at a time when most people engaged in hard physical labor in agriculture or industry, and were both suspicious and resentful of people who simply sat around handling pieces of paper, while producing nothing that could be seen or felt. Centuries-old hostilities have arisen—and have been acted upon—against minority groups who played such roles, whether they were Jews in Europe, overseas Chinese minorities in Southeast Asia, or Chettiars in their native India or in Burma, East Africa, or Fiji. Often such groups have been expelled or harassed into leaving the country—sometimes by mob violence—because of popular beliefs that they were parasitic.

  Those with such misconceptions have then often been surprised to discover economic activity and the standard of living declining in the wake of their departure. An understanding of basic economics could have prevented many human tragedies, as well as many economic inefficiencies.

  RETURNS ON INVESTMENT

  Delayed rewards for costs incurred earlier are a return on investment, whether these rewards take the form of dividends paid on corporate stock or increases in incomes resulting from having gone to college or medical school. One of the largest investments in many people’s lives consists of the time and energy expended over a period of years in raising their children. At one time, the return on that investment included having the children take care of the parents in old age, but today the return on this investment often consists only of the parents’ satisfaction in seeing their children’s well-being and progress. From the standpoint of society as a whole, each generation that makes this investment in its offspring is repaying the investment that was made by the previous generation in raising those who are parents today.

  “Unearned Income”

  Although making investments and receiving the delayed return on those investments takes many forms and has been going on all over the world throughout the history of the human race, misunderstandings of this process have also been long standing and widespread. Sometimes these delayed benefits are called “unearned” income, simply because they do not represent rewards for contributions made during the current time period. Investments that build a factory may not be repaid until years later, after workers and managers have been hired and products manufactured and sold.

  During the particular year when dividends finally begin to be paid, investors may not have contributed anything, but this does not mean that the reward they receive is “unearned,” simply because it was not earned by an investment made during that particular year.

  What can be seen physically is always more vivid than what cannot be seen. Those who watch a factory in operation can see the workers creating a product before their eyes. They cannot see the investment which made that factory possible in the first place. Risks are invisible, even when they are present risks, and the past risks surrounding the initial creation of the business are readily forgotten by observers who see only a successful enterprise after the fact.

  Also easily overlooked are the many management decisions that had to be made in determining where to locate, what kind of equipment to acquire, and what policies to follow in dealing with suppliers, consumers, and employees—any one of which decisions could spell the difference between success and failure. And of course what also cannot be seen are all the similar businesses that went out of business because they did not do all the things done by the surviving business we see before our eyes, or did not do them equally well.

  It is easy to regard the visible factors as the sole or most important factors, even when other businesses with those same visible factors went bankrupt, while an expertly managed enterprise in the same industry flourished and grew. Nor are such misunderstandings inconsequential, either economically or politically. Many laws and government economic policies have been based on these misunderstandings. Elaborate ideologies and mass movements have also been based on the notion that only the workers “really” create wealth, while others merely skim off profits, without having contributed anything to producing the wealth in which they unjustly share.

  Such misconceptions have had fateful consequences for money-lenders around the world. For many centuries, money-lenders have been widely condemned in many cultures for receiving back more money than they lent—that is, for getting an “unearned” income for waiting for payment and for taking risks. Often the social stigma attached to money-lending has been so great that only minorities who lived outside the existing social system anyway have been willing to take on such stigmatized activities. Thus, for centuries, Jews predominated in such occupations in Europe, as the Chinese did in Southeast Asia, the Chettiars and Marwaris in India, and other minority groups in other parts of the world.

  Misconceptions about money-lending often take the form of laws attempting to help borrowers by giving them more leeway in repaying loans. But anything that makes it difficult to collect a debt when it is due makes it less likely that loans will be made in the first place, or will be made at the lower interest rates that would prevail in the absence of such debtor-protection policies by governments.

  In some societies, people are not expected to charge interest on loans to relatives or fellow members of the local community, nor to be insistent on prompt payment according to the letter of the loan agreement. These kinds of preconditions discourage loans from being made in the first place, and sometimes they discourage individuals from letting it be known that they have enough money to be able to lend. In societies where such social pressures are particularly strong, incentives for acquiring wealth are reduced. This is not only a loss to the individual who might otherwise have made wealth by going all out, it is a loss to the whole society when people who are capable of producing things that many others are willing to pay for may not c
hoose to go all out in doing so.

  Investment and Allocation

  Interest, as the price paid for investment funds, plays the same allocational role as other prices in bringing supply and demand into balance. When interest rates are low, it is more profitable to borrow money to invest in building houses or modernizing a factory or launching other economic ventures. On the other hand, low interest rates reduce the incentives to save. Higher interest rates lead more people to save more money but lead fewer investors to borrow that money when borrowing is more expensive. As with supply and demand for products in general, imbalances between supply and demand for money lead to rises or falls in the price—in this case, the interest rate. As The Economist magazine put it:

  Most of the time, mismatches between the desired levels of saving and investment are brought into line fairly easily through the interest-rate mechanism. If people’s desire to save exceeds their desire to invest, interest rates will fall so that the incentive to save goes down and the willingness to invest goes up.{440}

  In an unchanging world, these mismatches between savings and investment would end, and investors would invest the same amount that savers were saving, with the result that interest rates would be stable because they would have no reason to change. But, in the real world as it is, interest rate fluctuations, like price fluctuations in general, constantly redirect resources in different directions as technology, demand and other factors change. Because interest rates are symptoms of an underlying reality, and of the constraints inherent in that reality, laws or government policies that change interest rates have repercussions far beyond the purpose for which the interest rate is changed, with reverberations throughout the economy.

  For example, when the U.S. Federal Reserve System in the early twenty-first century lowered interest rates, in order to try to sustain production and employment, in the face of signs that the growth of national output and employment might be slowing down, the repercussions included an increase in the prices of houses. Lower interest rates meant lower mortgage payments and therefore enabled more people to be able to afford to buy houses. This in turn led fewer people to rent apartments, so that apartment rents fell because of a reduced demand. Artificially low interest rates also provided fewer incentives for people to save.

  These were just some of many changes that spread throughout the economy, brought about by the Federal Reserve’s changes in interest rates. More generally, this showed how intricately all parts of a market economy are tied together, so that changes in one part of the system are transmitted automatically to innumerable other parts of the system.

  Not everything that is called interest is in fact interest, however. When loans are made, for example, what is charged as interest includes not only the rate of return necessary to compensate for the time delay in receiving the money back, but also an additional amount to compensate for the risk that the loan will not be repaid, or repaid on time, or repaid in full. What is called interest also includes the costs of processing the loan. With small loans, especially, these process costs can become a significant part of what is charged because process costs do not vary as much as the amount of the loan varies. That is, lending a thousand dollars does not require ten times as much paperwork as lending a hundred dollars.

  In other words, process costs on small loans can be a larger share of what is loosely called interest. Many of the criticisms of small financial institutions that operate in low-income neighborhoods grow out of misconstruing various charges that are called interest but are not, in the strict sense in which economists use the term for payments received for time delay in receiving repayment and the risk that the repayment will not be made in full or on time, or perhaps at all.

  Short-term loans to low-income people are often called “payday loans,” since they are to be repaid on the borrower’s next payday or when a Social Security check or welfare check arrives, which may be only a matter of weeks, or even days, away. Such loans, according to the Wall Street Journal, are “usually between $300 and $400.”{441} Obviously, such loans are more likely to be made to people whose incomes and assets are so low that they need a modest sum of money immediately for some exigency and simply do not have it.

  The media and politicians make much of the fact that the annual rate of interest (as they loosely use the term “interest”) on these loans is astronomical. The New York Times, for example referred to “an annualized interest rate of 312 percent”{442} on some such loans. But payday loans are not made for a year, so the annual rate of interest is irrelevant, except for creating a sensation in the media or in politics. As one owner of a payday loan business pointed out, discussing annual interest rates on payday loans is like saying salmon costs more than $15,000 a ton or a hotel room rents for more than $36,000 a year, {443}since most people never buy a ton of salmon or rent a hotel room for a year.

  Whatever the costs of processing payday loans, those costs as well as the cost of risk must be recovered from the interest charged—and the shorter the period of time involved, the higher the annual interest rate must be to cover those fixed costs. For a two-week loan, payday lenders typically charge $15 in interest for every $100 lent. When laws restrict the annual interest rate to 36 percent, this means that the interest charged for a two-week loan would be less than $1.50—an amount unlikely to cover even the cost of processing the loan, much less the risk involved. When Oregon passed a law capping the annual interest rate at 36 percent, three-quarters of the hundreds of payday lenders in the state closed down.{444} Similar laws in other states have also shut down many payday lenders.{445}

  So-called “consumer advocates” may celebrate such laws but the low-income borrower who cannot get the $100 urgently needed may have to pay more than $15 in late fees on a credit card bill or pay in other consequences—such as having a car repossessed or having the electricity cut off—that the borrower obviously considered more detrimental than paying $15, or the transaction would not have been made in the first place.

  The lower the interest rate ceiling, the more reliable the borrowers would have to be, in order to make it pay to lend to them. At a sufficiently low interest rate ceiling, it would pay to lend only to millionaires and, at a still lower interest rate ceiling, it would pay to lend only to billionaires. Since different ethnic groups have different incomes and different average credit scores, interest rate ceilings virtually guarantee that there will be disparities in the proportions of these groups who are approved for mortgage loans, credit cards and other forms of lending.

  In the United States, for example, Asian Americans have higher average credit scores than Hispanic Americans or black Americans—or white Americans, {446}for that matter. Yet people who favor interest rate ceilings are often shocked to discover that some racial or ethnic groups are turned down for mortgage loans more often than others, and attribute this to racial discrimination by the lenders. But, since most American lenders are apt to be white, and they turn down whites at a much higher rate than they turn down Asian Americans, racial discrimination seems an unlikely explanation.

  Where there are lenders who specialize in large, short-term loans to high-income people with expensive possessions to use as collateral, these “collateral lenders” (essentially pawn shops for the affluent or rich) charge interest rates that can exceed 200 percent on an annual basis. These interest rates are high for the same reasons that payday loans to low-income people are high. But, because the high-income loans are secured by collateral that can be sold if the loan is not repaid, the high interest rates are not as high as with loans to low-income people without collateral. Moreover, because a collateral lender like Pawngo makes loans averaging between $10,000 to $15,000,{447} the fixed process costs are a much smaller percentage of the loans, and so add correspondingly less to the interest rate charged.

  SPECULATION

  Most market transactions involve buying things that exist, based on whatever value they have to the buyer and whatever price is charged by the seller. Some transaction
s, however, involve buying things that do not yet exist or whose value has yet to be determined—or both. For example, the price of stock in the Internet company Amazon.com rose for years before the company made its first dollar of profits. People were obviously speculating that the company would eventually make profits or that others would keep bidding up the price of its stock, so that the initial stockholder could sell the stock for a profit, whether or not Amazon.com itself ever made a profit. Amazon.com was founded in 1994. After years of operating at a loss, it finally made its first profit in 2001.

  Exploring for oil is another costly speculation, since millions of dollars may be spent before discovering whether there is in fact any oil at all where the exploration is taking place, much less whether there is enough oil to repay the money spent.

  Many other things are bought in hopes of future earnings which may or may not materialize—scripts for movies that may never be made, pictures painted by artists who may or may not become famous some day, and foreign currencies that may go up in value over time, but which could just as easily go down. Speculation as an economic activity may be engaged in by people in all walks of life but there are also professional speculators for whom this is their whole career.