Basic Economics

by Thomas Sowell

  With time comes risk, given the limitations of human foresight. This inherent risk must be sharply distinguished from the kinds of risk that are created by such activities as gambling or playing Russian roulette. Economic activities for dealing with inescapable risks seek both to minimize these risks and shift them to those best able to carry them. Those who accept these risks typically have not only the financial resources to ride out short-run losses but also have lower risks from a given situation than the person who transferred the risk. A commodity speculator can reduce risks overall by engaging in a wider variety of risky activities than a farmer does, for example.

  While a wheat farmer can be wiped out if bumper crops of wheat around the world force the price far below what was expected when the crop was planted, a similar disaster would be unlikely to strike wheat, gold, cattle, and foreign currencies simultaneously, so that a professional speculator who speculated in all these things would be in less danger than someone who speculated in any one of them, as a wheat farmer does.

  Whatever statistical or other expertise the speculator has further reduces the risks below what they would be for the farmer or other producer. More fundamentally, from the standpoint of the efficient use of scarce resources, speculation reduces the costs associated with risks for the economy as a whole. One of the important consequences, in addition to more people being able to sleep well at night because of having a guaranteed market for their output, is that more people find it worthwhile to produce things under risky conditions than would have otherwise. In other words, the economy can produce more soybeans because of soybean speculators, even if the speculators themselves know nothing about growing soybeans.

  It is especially important to understand the interlocking mutual interests of different economic groups—the farmer and the speculator being just one example—and, above all, the effects on the economy as a whole, because these are things often neglected or distorted in the zest of the media for emphasizing conflicts, which is what sells newspapers and gets larger audiences for television news programs. Politicians likewise benefit from portraying different groups as enemies of one another and themselves as the saviors of the group they claim to represent.

  When wheat prices soar, for example, nothing is easier for a demagogue than to cry out against the injustice of a situation where speculators, sitting comfortably in their air-conditioned offices, grow rich on the sweat of farmers toiling in the fields for months under a hot sun. The years when the speculators took a financial beating at harvest time, while the farmers lived comfortably on the guaranteed wheat prices paid by speculators, are of course forgotten.

  Similarly, when an impending or expected shortage drives up prices, much indignation is often expressed in politics and the media about the higher retail prices being charged for things that the sellers bought from their suppliers when prices were lower. What things cost under earlier conditions is history; what the supply and demand are today is economics.

  During the early stages of the 1991 Persian Gulf War, for example, oil prices rose sharply around the world, in anticipation of a disruption of Middle East oil exports because of impending military action in the region. At this point, a speculator rented an oil tanker and filled it with oil purchased in Venezuela to be shipped to the United States. However, before the tanker arrived at an American port, the Gulf War of 1991 was over sooner than anyone expected and oil prices fell, leaving the speculator unable to sell his oil for enough to recover his costs. Here too, what he paid in the past was history and what he could get now was economics.

  From the standpoint of the economy as a whole, different batches of oil purchased at different times, under different sets of expectations, are the same when they enter the market today. There is no reason why they should be priced differently, if the goal is to allocate scarce resources in the most efficient way.

  Time and Politics

  Politics and economics differ radically in the way they deal with time. For example, when it becomes clear that the fares being charged on municipal buses are too low to permit those buses to be replaced as they wear out, the logical economic conclusion for the long run is to raise the fares. However, a politician who opposes the fare increase as “unjustified” may gain the votes of bus riders at the next election. Moreover, since all the buses are not going to wear out immediately, or even simultaneously at some future date, the consequences of holding down the fare will not appear all at once but will be spread out over time. It may be some years before enough buses start breaking down and wearing out, without adequate replacements, for the bus riders to notice that there now seem to be longer waits between buses and buses do not arrive on schedule as often as they used to.

  By the time the municipal transit system gets so bad that many people begin moving out of the city, taking the taxes they pay with them, so many years may have elapsed since the political bus fare controversy that few people remember it or see any connection between that controversy and their current problems. Meanwhile, the politician who won municipal elections by assuming the role of champion of the bus riders may now have moved on up to statewide office, or even national office, on the basis of that popularity. As a declining tax base causes deteriorating city services and neglected infrastructure, the erstwhile hero of the bus riders may even be able to boast that things were never this bad when he was a city official, and blame the current problems on the failings of his successors.

  In economics, however, future consequences are anticipated in the concept of “present value.” If, instead of fares being regulated by a municipal government, these fares were set by a private bus company operating in a free market, any neglect of financial provisions for replacing buses as they wear out would begin immediately to reduce the value of the bus company’s stock. In other words, the present value of the bus company would decline as a result of the long-run consequences anticipated by professional investors concerned about the safety and profitability of their own money.

  If a private bus company’s management decided to keep fares too low to maintain and replace its buses as they wore out, perhaps deciding to pay themselves higher executive salaries instead of setting aside funds for the maintenance of their bus fleet, 99 percent of the public might still be unaware of this or its long-run consequences. But among the other one percent who would be far more likely to be aware would be those in charge of financial institutions that owned stock in the bus company, or were considering buying that stock or lending money to the bus company. For these investors, potential investors, or lenders examining financial records, the company’s present value would be seen as reduced, long before the first bus wore out.

  As in other situations, a market economy allows accurate knowledge to be effective in influencing decision-making, even if 99 percent of the population do not have that knowledge. In politics, however, the 99 percent who do not understand can create immediate political success for elected officials and for policies that will turn out in the end to be harmful to society as a whole. It would of course be unreasonable to expect the general public to become financial experts or any other kind of experts, since there are only 24 hours in the day and people have lives to lead. What may be more reasonable is to expect enough voters to see the dangers in letting many economic decisions be made through political processes.

  Time can turn economies of scale from an economic advantage to a political liability. After a business has made a huge investment in a fixed installation—a gigantic automobile factory, a hydroelectric dam or a skyscraper, for example—the fact that this asset cannot be moved makes it a tempting target for high local taxation or for the unionization of employees who can shut it down with a strike and impose huge losses unless their demands are met. Where labor costs are a small fraction of the total costs of an enterprise with a huge capital investment, even a doubling of wages may be a price worth paying to keep a multi-billion-dollar operation going. This does not mean that investors will simply accept a permanently reduced rate of ret
urn in this company or industry. As in other aspects of an economy, a change in one factor has repercussions elsewhere.

  While a factory or dam cannot be moved, an office staff—even the headquarters staff of a national or international corporation—can much more readily be relocated elsewhere, as New York discovered after its high taxes caused many of its big corporations to move their headquarters out of the city.

  With enough time, even many industries with huge fixed installations can change their regional distribution—not by physically moving existing dams, buildings, or other structures, but by not building any new ones in the unpromising locations where the old ones are, and by placing new and more modern structures and installations in states and localities with a better track record of treating businesses as economic assets, rather than economic prey. Meanwhile, places that treated businesses as prey—Detroit being a classic example—are sympathized with as victims of bad luck when the businesses leave and take their taxes and jobs with them.

  A hotel cannot move across state lines, but a hotel chain can build their new hotels somewhere else. New steel mills with the latest technology can likewise be built elsewhere, while the old obsolete steel mill is closed down or phased out. As in the case of bus fares kept too low to sustain the same level and quality of service in the long run, here too the passage of time may be so long that few people connect the political policies and practices of the past with the current deterioration of the region into “rustbelt” communities with declining employment opportunities for its young people and a declining tax base to support local services.

  “Rustbelts” are not simply places where jobs are disappearing. Jobs are always disappearing, even at the height of prosperity. The difference is that old jobs are constantly being replaced by new jobs in places where businesses are allowed to flourish. But in rustbelt communities or regions that have made businesses unprofitable with high taxes, red tape and onerous requirements by either governments or labor unions that impair efficiency, there may not be nearly as many new jobs as would be required to replace the old jobs that disappear with the passage of time and the normal changes in economic circumstances.

  While politicians or people in the media may focus on the old jobs that have disappeared, the real story consists of the new jobs that do not come to replace them, but go elsewhere instead of to rustbelt communities that have made themselves hostile environments for economic activity.

  Time and Foresight

  Even though many government officials may not look ahead beyond the next election, individual citizens who are subjected to the laws and policies that officials impose nevertheless have foresight that causes many of these laws and policies to have very different consequences from those that were intended. For example, when money was appropriated by the U.S. government to help children with learning disabilities and psychological problems, the implicit assumption was that there was a more or less given number of such children. But the availability of the money created incentives for more children to be classified into these categories. Organizations running programs for such children had incentives to diagnose problem children as having the particular problem for which government money was available. Some low-income mothers on welfare have even told their children to do badly on tests and act up in school, so as to add more money to their meager household incomes.

  New laws and new government policies often have unanticipated consequences when those subject to these laws and policies react to the changed incentives. For example, getting relief from debts through bankruptcy became more difficult for Americans under a new law passed in 2005. Prior to this law, the number of bankruptcy filings in the United States averaged about 30,000 a week but, just before the new law went into effect, the number of bankruptcy filings spiked at more than 479,000 per week—and immediately afterwards fell below 4,000 a week.{524} Clearly, some people anticipated the change in the bankruptcy law and rushed to file before the new law took effect.

  Where Third World governments have contemplated confiscation of land for redistribution to poor farmers, many years can elapse between the political campaign for redistribution of land and the time when the land is actually transferred. During those years, the foresight of existing landowners is likely to lead them to neglect to maintain the property as well as they did when they expected to reap the long-term benefits of investing time and money in weeding, draining, fencing and otherwise caring for the land. By the time the land actually reaches the poor, it may be much poorer land. As one development economist put it, land reform can be “a bad joke played on those who can least afford to laugh.”{525}

  The political popularity of threatening to confiscate the property of rich foreigners—whether land, factories, railroads or whatever—has led many Third World leaders to make such threats, even when they were too fearful of the economic consequences to actually carry out these threats. Such was the case in Sri Lanka in the middle of the twentieth century:

  Despite the ideological consensus that the foreign estates should be nationalized, the decision to do so was regularly postponed. But it remained a potent political threat, and not only kept the value of the shares of the tea companies on the London exchange low in relation to their dividends, but also tended to scare away foreign capital and enterprise.{526}

  Even very general threats or irresponsible statements can affect investment, as in Malaysia, during an economic crisis:

  Malaysia’s prime minister, Mahathir Mohamad, tried to blame Jews and whites who “still have the desire to rule the world,” but each time he denounced some foreign scapegoat, his currency and stock market fell another 5 percent. He grew quieter.{527}

  In short, people have foresight, whether they are landowners, welfare mothers, investors, taxpayers or whatever. A government which proceeds as if the planned effect of its policies is the only effect often finds itself surprised or shocked because those subject to its policies react in ways that benefit or protect themselves, often with the side effect of causing the policies to produce very different results from what was planned.

  Foresight takes many forms in many different kinds of economies. During periods of inflation, when people spend money faster, they also tend to hoard consumer goods and other physical assets, accentuating the imbalance between the reduced amount of real goods available in the market and the increased amount of money available to purchase these goods. In other words, they anticipate future difficulties in finding goods that they will need or in having assets set aside for a rainy day, when money is losing its value too rapidly to fulfill that role as well. During the runaway inflation in the Soviet Union in 1991, both consumers and businesses hoarded:

  Hoarding reached unprecedented proportions, as Russians stashed huge supplies of macaroni, flour, preserved vegetables, and potatoes on their balconies and filled their freezers with meat and other perishable goods.{528}

  Business enterprises likewise sought to deal in real goods, rather than money:

  By 1991, enterprises preferred to pay each other in goods rather than rubles. (Indeed, the cleverest factory managers struck domestic and international barter deals that enabled them to pay their employees, not with rubles, but with food, clothing, consumer goods, even Cuban rum.){529}

  Both social and economic policies are often discussed in terms of the goals they proclaim, rather than the incentives they create. For many, this may be due simply to shortsightedness. For professional politicians, however, the fact that their time horizon is often bounded by the next election means that any goal that is widely accepted can gain them votes, while the long-run consequences come too late to be politically relevant at election time, and the lapse of time can make the connection between cause and effect too difficult to prove without complicated analysis that most voters cannot or will not engage in.

  In the private marketplace, however, experts can be paid to engage in such analysis and exercise such foresight. Thus the bond-rating services Moody’s and Standard & Poor’s downgraded Cal
ifornia’s state bonds in 2001, {530} even though there had been no default and the state budget still had a surplus in its treasury. What Moody’s and Standard & Poor’s realized was that the huge costs of dealing with California’s electricity crisis were likely to strain the state’s finances for years to come, raising the possibility of a default on state bonds or a delay in payment, which amounts to a partial default. A year after these agencies had downgraded the state’s bonds, it became public knowledge that the state’s large budget surplus had suddenly turned into an even larger budget deficit—and many people were shocked by the news.

  PART V:

  THE NATIONAL ECONOMY

  Chapter 16

  NATIONAL OUTPUT

  Commonsense observation as well as statistics are necessary for assessing the success of an economy.

  Theodore Dalrymple{531}

  Just as there are basic economic principles which apply in particular markets for particular goods and services, so there are principles which apply to the economy as a whole. For example, just as there is a demand for particular goods and services, so there is an aggregate demand for the total output of the whole nation. Moreover, aggregate demand can fluctuate, just as demand for individual products can fluctuate. In the four years following the great stock market crash of 1929, the money supply in the United States declined by a staggering one-third.{532} This meant that it was now impossible to continue to sell as many goods and hire as many people at the old price levels, including the old wage levels.

  If prices and wage rates had also declined immediately by one-third, then of course the reduced money supply could still have bought as much as before, and the same real output and employment could have continued. There would have been the same amount of real things produced, just with smaller numbers on their price tags, so that paychecks with smaller numbers on them could have bought just as much as before. In reality, however, a complex national economy can never adjust that fast or that perfectly, so there was a massive decline in total sales, with corresponding declines in production and employment. The nation’s real output in 1933 was one-fourth lower than it was in 1929.{533}