Basic Economics

by Thomas Sowell

  Petroleum is by no means unique in having its supply affected by prices. The same is true for the production of nickel as well, for example. When the price of nickel rose in the early twenty-first century, the Wall Street Journal reported:

  A few years ago, it would have been hard to find a better example of a failed mining project than Murrin Murrin, a huge, star-crossed nickel operation deep in the Western Australian desert.

  Now, Murrin Murrin is an investor favorite. Shares of the company that runs it. . .have more than tripled in the past year, and some analysts see room for more.

  The surprising turnaround highlights a central fact of the current commodity boom: With prices this high—especially for nickel—even technically difficult or chronically troubled projects look good. Nickel is most widely used to make stainless steel.{474}

  Although the reserves of natural resources in a nation are often discussed in terms of physical quantities, economic concepts of cost, prices, and present values must be considered if practical conclusions are to be reached. In addition to needless alarms about natural resources running out, there have also been, conversely, unjustifiably optimistic statements that some poor country has so many billions of dollars’ worth of “natural wealth” in the form of iron ore or bauxite deposits or some other natural resource.

  Such statements mean very little without considering how much it would cost to extract and process those resources—and this varies greatly from place to place. Extraction of petroleum from Canada’s oil sands, for example, costs so much that until recent years the oil there was not even counted in the world’s petroleum reserves. But, when the price of oil shot up past $100 a barrel, Canada became one of the world’s leaders in petroleum reserves.

  Chapter 14

  STOCKS, BONDS AND

  INSURANCE

  Risk-taking is the mother’s milk of capitalism.

  Wall Street Journal{475}

  Risks inherent in economic activities can be dealt with in a wide variety of ways. In addition to the commodity speculation and inventory management discussed in the previous chapter, other ways of dealing with risk include stocks and bonds. There are also other economic activities analogous to stocks and bonds which deal with risks in ways that are legally different, though similar economically.

  Whenever a home, a business, or any other asset increases in value over time, that increase is called a “capital gain.” While it is another form of income, it differs from wages and salaries in not being paid right after it is earned, but usually only after an interval of some years. A thirty-year bond, for example, can be cashed in only after thirty years. If you never sell your home, then whatever increase in value it has will be called an “unrealized capital gain.” The same is true for someone who opens a grocery store that grows more valuable as its location becomes known throughout the neighborhood, and as it develops a set of customers who get into the habit of shopping at that particular store. Perhaps after the owner dies, the surviving spouse or children may decide to sell the store—and only then will the capital gain be realized.

  Sometimes a capital gain comes from a purely financial transaction, where you simply pay someone a certain amount of money today in order to get back a somewhat larger amount of money later on. This happens when you put money into a savings account that pays interest, or when a pawnbroker lends money, or when you buy a $10,000 U. S. Treasury bond for somewhat less than $10,000.

  However it is done, this is a trade-off of money today for money in the future. The fact that interest is paid implies that money today is worth more than the same amount of money in the future. How much more depends on many things, and varies from time to time, as well as from country to country at the same time.

  In the heyday of nineteenth-century British industrialization, railroad companies could raise the huge sums of money required to build miles of tracks and buy trains, by selling bonds that paid about 5 percent per year.{476} This was possible only because the public had great confidence in both the railroads and the stability of the money. If the rate of inflation had been 6 percent a year, those who bought the bonds would have lost real value instead of gaining it. But the value of the British pound sterling was very stable and reliable during that era.

  Since those times, inflation has become more common, so the interest rate would now have to cover whatever level of inflation was expected and still leave a prospect of a real gain in terms of an increase in purchasing power. The risk of inflation varies from country to country and from one era to another, so the rate of return on investments must include an allowance for the risk of inflation, which also varies. At the beginning of the twenty-first century, Mexico’s government bonds paid 2.5 percentage points higher interest than those of the United States, while those of Brazil paid five percentage points higher than those of Mexico. Brazil’s interest rate then shot up another ten percentage points after the emergence of a left-wing candidate for president of the country.{477}

  In short, varying risks—of which inflation is just one—are reflected in varying risk premiums added on to the underlying pure interest rate, which is a payment for postponed repayment. The risk premium component included in what is more loosely and more generally called the interest rate can become larger than what economists might call the pure interest rate. As of April 2003, for example, short-term interest rates (in the more general sense) ranged from less than 2 percent in Hong Kong to 18 percent in Russia and 39 percent in Turkey.{478}

  Leaving inflation aside, how much would a $10,000 bond that matures a year from now be worth to you today? That is, how much would you bid today for a bond that can be cashed in for $10,000 next year? Clearly it would not be worth $10,000, because future money is not as valuable as the same amount of present money. Even if you felt certain that you would still be alive a year from now, and even if there were no inflation expected, you would still prefer to have the same amount of money right now rather than later. If nothing else, money that you have today can be put in a bank and earn a year’s interest on it. For the same reason, if you had a choice between buying a bond that matures a year from now and another bond of the same face value that matures ten years from now, you would not be willing to bid as much for the one that matures a decade later.

  What this says is that the same nominal amount of money has different values, depending on how long you must wait to receive it. At a sufficiently high interest rate, you might be willing to wait decades to get your money back. People buy 30-year bonds regularly, though usually at a higher rate of return than what is paid on financial securities that mature in a year. On the other hand, at a sufficiently low interest rate, you would not be willing to wait any time at all to get your money back.

  Somewhere in between is an interest rate at which you would be indifferent between lending money or keeping it. At that interest rate, the present value of a given amount of future money is equal to some smaller amount of present money. For example if you are indifferent at 4 percent, then a hundred dollars today is worth $104 a year from now to you. Any business or government agency that wants to borrow $100 from you today with a promise to pay you back a year from now will have to make that repayment at least $104. If everyone else has the same preferences that you do, then the interest rate in the economy as a whole will be 4 percent.

  What if everyone does not have the same preferences that you do? Suppose that others will lend only when they get back 5 percent more at the end of the year? In that case, the interest rate in the economy as a whole will be 5 percent, simply because businesses and government cannot borrow the money they want for any less and they do not have to offer any more. Faced with a national interest rate of 5 percent, you would have no reason to accept less, even though you would take 4 percent if you had to.

  In this situation, let us return to the question of how much you would be willing to bid for a $10,000 bond that matures a year from now. With an interest rate of 5 percent being available in the economy as a whole, it would not p
ay you to bid more than $9,523.81 for a $10,000 bond that matures a year from now. By investing that same amount of money somewhere else today at 5 percent, you could get back $10,000 in a year. Therefore, there is no reason for you to bid more than $9,523.81 for the $10,000 bond.

  What if the interest rate in the economy as a whole had been 12 percent, rather than 5 percent? Then it would not pay you to bid more than $8,928.57 for a $10,000 bond that matures a year from now. In short, what people will bid for bonds depends on how much they could get for the same money by putting it somewhere else. That is why bond prices go down when the interest rate goes up, and vice versa.

  What this also says is that, when the interest rate is 5 percent, $9,523.81 in the year 2014 is the same as $10,000 in the year 2015. This raises questions about the taxation of capital gains. If someone buys a bond for the former price and sells it a year later for the latter price, the government will of course want to tax the $476.19 difference. But is that really the same as an increase in value, if the two sums of money are just equivalent to one another? What if there has been a one percent inflation, so that the $10,000 received back would not have been enough to compensate for waiting, if the investor had expected inflation to reduce the real value of the bond? What if there had been a 5 percent inflation, so that the amount received back was worth no more than the amount originally lent, with no reward at all for waiting for the postponed repayment? Clearly, the investor would be worse off than if he or she had never bought the bond. How then can this “capital gain” really be said to be a gain?

  These are just some of the considerations that make the taxation of capital gains more complicated than the taxation of such other forms of income as wages and salaries. Some governments in some countries do not tax capital gains at all, while the rate at which such gains are taxed in the United States remains a matter of political controversy.

  VARIABLE RETURNS VERSUS

  FIXED RETURNS

  There are many ways of confronting the fact that the real value of a given sum of money varies with when it is received and with the varying likelihood that it will be received at all. Stocks and bonds are among the many ways of dealing with differing risks. But people who are not considering buying these financial securities must nevertheless confront the same principles in other ways, when choosing a career for themselves or when considering public policy issues for the country as a whole.

  Stocks versus Bonds

  Bonds differ from stocks because bonds are legal commitments to pay fixed amounts of money on a fixed date. Stocks are simply shares of the business that issues them, and there is no guarantee that the business will make a profit in the first place, much less pay out dividends instead of re-investing their profits in the business itself. Bondholders have a legal right to be paid what they were promised, whether the business is making money or losing money. In that respect, they are like the business’ employees, to whom fixed commitments have been made as to how much they would be paid per hour or per week or month. They are legally entitled to those amounts, regardless of whether the business is profitable or unprofitable. The owners of a business—whether that is a single individual or millions of stockholders—are not legally entitled to anything, except whatever happens to be left over after a business has paid its employees, bondholders and other creditors.

  Considering the fact that most new businesses fail within a few years, what is left over can just as easily be negative as positive. In other words, people who set up businesses may not only fail to make a profit but may even lose part or all of what they originally invested. In short, stocks and bonds have different amounts of risk. Moreover, the mixture of stocks and bonds sold by different kinds of businesses may reflect the inherent risks of these businesses themselves.

  Imagine that someone is raising money to go into a business where (1) the chances are 50–50 that he will go bankrupt and (2) if the business does survive financially, the value of the initial investment will increase ten-fold. Perhaps the entrepreneur is drilling for oil or speculating in foreign currencies. What if the entrepreneur wants you to contribute $5,000 to this venture? Would you be better off buying $5,000 worth of stock in this enterprise or $5,000 worth of this company’s bonds?

  If you buy bonds, your chances are still only 50–50 of getting all your money back. And if this enterprise prospers, you are only entitled to whatever rate of return was specified in the bond at the outset, no matter how many millions of dollars the entrepreneur makes with your money. Buying bonds in such a venture would obviously not be a worthwhile deal. Buying stocks, on the other hand, might make sense, if you can afford the risk. If the business goes bankrupt, your stock could be worthless, while a bond would have some residual value, based on whatever assets might remain to be sold, even if that only pays the bondholders and other creditors pennies on the dollar. On the other hand, if the business succeeds and its assets increase ten-fold, then the value of your stock likewise increases ten-fold.

  This is the kind of investment often called “venture capital,” as distinguished from buying the stocks or bonds of some long-established corporation that is unlikely to either go bankrupt or to have a spectacular rate of return on its investments. As a rule of thumb, it has been estimated that a venture capitalist needs at least a 50 percent rate of return on successful investments, in order to cover the losses on the many unsuccessful investments and still come out ahead over all. In real life, rates of return on venture capital can vary greatly from year to year. For the 12 months ending September 30, 2001, venture capital funds lost 32.4 percent. That is, not only did these venture capitalists as a whole not make any net profit, they lost nearly one-third of the money they had invested. But, just a couple of years earlier venture capitalists averaged a rate of return of 163 percent.{479}

  The question of whether this kind of activity is worthwhile from the standpoint of the venture capitalist can be left to the venture capitalist to worry about. From the standpoint of the economy as a whole, the question is whether this kind of financial activity represents an efficient allocation of scarce resources which have alternative uses. Although individual venture capitalists can go bankrupt, just like the companies they invest in, the venture capital industry as a whole usually does not lose money—that is, it does not waste the available resources of the economy. It is in fact remarkable that something which looks as risky as venture capital usually works out from the standpoint of the economy as a whole, even if not from the standpoint of each venture capitalist.

  Now look at stocks and bonds from the standpoint of the entrepreneur who is trying to raise money for a risky undertaking. Knowing that bonds would be unattractive to investors and that a bank would likewise be reluctant to lend to him because of the high risks, the entrepreneur would almost certainly try to raise money by selling stocks instead. At the other end of the risk spectrum, consider a public utility that supplies something for which the public has a continuing demand, such as water or electricity. There is usually very little risk involved in putting money into such an enterprise, so the utility can issue and sell bonds, without having to pay the higher amounts that investors would earn on stocks.{xxi} In recent years, some pension funds seeking safe, long-run investments from which to pay their retirees have invested in the building of toll highways, from whose receipts they can expect a continuing stream of returns for years to come.{480}

  In short, risks vary among businesses and their financial arrangements vary accordingly. At one extreme, a commodity speculator can go from profits to losses and back again, not only from year to year but even from hour to hour on a given day. That is why there are television pictures of frantic shouting and waving in commodity exchanges, where prices are changing so rapidly that the difference between making a deal right now and making it five minutes from now can be vast sums of money.

  A more common pattern among those businesses that succeed is one of low income or no income at the beginning, followed by higher earnings after the enterprise
develops a clientele and establishes a reputation. For example, a dentist first starting out in his profession after graduating from dental school and buying the costly equipment needed to get started, may have little or no net income the first year, before becoming known widely enough in the community to attract a large clientele. During that interim, the dentist’s secretary may be making more money than the dentist. Later on, of course, the situation will reverse and some observers may then think it unfair that the dentist makes several times the income of the secretary.

  Even when variable sums of money add up to the same total as fixed sums of money, they are unlikely to be equally attractive. Would you be equally as likely to enter two occupations with the same average income—say, $50,000 a year—over the next decade if one occupation paid $50,000 every year while the income in the other occupation might vary from $10,000 one year to $90,000 the next year and back again, in an unpredictable pattern? Chances are you would require a somewhat higher average income in the occupation with variable pay, to make it equally attractive with the occupation with a reliably fixed income. Accordingly, stocks usually yield a higher average rate of return than bonds, since stocks have a variable rate of return (including, sometimes, no return at all), while bonds have a guaranteed fixed rate of return. It is not some moral principle that makes this happen. It happens because people will not take the risk of buying stocks unless they can expect a higher average rate of return than they get from bonds.

  The degree of risk varies not only with the kind of investment but also with the period of time involved. For a period of one year, bonds are likely to be much safer than stocks. But for a period of 20 or 30 years, the risk of inflation threatens the value of bonds or other assets with fixed-dollar amounts, such as bank accounts, while stock prices tend to rise with inflation like real estate, factories, or other real assets. Being shares of real assets, stocks rise in price as the assets themselves rise in price during inflation. Therefore the relative safety of stocks and bonds can be quite different in the long run than in the short run.