Basic Economics

by Thomas Sowell

  Various economists’ estimates of the upward bias of the consumer price index average about one percentage point or more. That means that when the consumer price index shows 3 percent inflation per year, it is really more like 2 percent inflation per year. That might seem like a small difference but the consequences are not small. A difference of one percentage point per year, compounded over a period of 25 years, means that in the end the average American income per person is under-estimated by almost $9,000 a year.{546} In other words, at the end of a quarter-century, an American family of three has a real income of more than $25,000 a year higher than the official statistics on real wages would indicate.

  Alarms in the media and in politics about statistics showing declining real wages over time have often been describing a statistical artifact rather than an actual fact of life. It was during a period of “declining real wages” that the average American’s consumption increased dramatically and the average American’s net worth more than doubled.

  A further complication in measuring changes in the standard of living is that more of the increase in compensation for work takes the form of job-related benefits, rather than direct wages. Thus, in the United States, total compensation rose during a span of years when there were “declining real wages.”

  International Comparisons

  The same problems which apply when comparing a given country’s output over time can also apply when comparing the output of two very different countries at the same time. If some Caribbean nation’s output consists largely of bananas and other tropical crops, while some Scandinavian country’s output consists more of industrial products and crops more typical of cold climates, how is it possible to compare totals made up of such differing items? This is not just comparing apples and oranges, it may be comparing cars and sugar.

  The qualitative differences found in output produced in the same country at different times are also found in comparisons of output from one country to another at a given time. In the days of the Soviet Union, for example, its products from cameras to cars were notorious for their poor quality and often technological obsolescence, while the service that people received from people working in Soviet restaurants or in the national airline, Aeroflot, was equally notorious for poor quality. When the watches produced in India during the 1980s were overwhelmingly mechanical watches, while most of the watches in the rest of the world were electronic, international comparisons of the output of watches were equally as misleading as comparisons of Soviet output with output in Western industrial nations.

  Moreover, a purely quantitative record of increased output in India, after many of its government restrictions on the economy were lifted in the late twentieth century, understates the economic improvement, by not being able to quantify the dramatic qualitative improvements in India’s watches, cars, television sets and telephone service, as these industries responded to increased competition from both domestic and international enterprises. These qualitative improvements ranged from rapid technological advances to being able to buy these goods and services immediately, instead of being put on waiting lists.

  Just as some statistics understate the economic differences between nations, other statistical data overstate these differences. Statistical comparisons of incomes in Western and non-Western nations are affected by the same age differences that exist among a given population within a given nation. For example, the median ages in Nigeria, Afghanistan, and Tanzania are all below twenty, while the median ages in Japan, Italy, and Germany are all over forty.{547} Such huge age gaps mean that the real significance of some international differences in income may be seriously overstated. Just as nature provides—free of charge—the heat required to grow pineapples or bananas in tropical countries, while other countries would run up huge heating bills growing those same fruits in greenhouses, so nature provides free for the young many things that can be very costly to provide for older people.

  Enormously expensive medications and treatments for dealing with the many physical problems that come with aging are all counted in statistics about a country’s output, but fewer such things are necessary in a country with a younger population. Thus statistics on real income per capita overstate the difference in economic well-being between older people in Western nations and younger people in non-Western nations.

  If it were feasible to remove from national statistics all the additional wheelchairs, pacemakers, nursing homes, and medications ranging from Geritol to Viagra—all of which are ways of providing for an older population things which nature provides free to the young—then international comparisons of real income would more accurately reflect actual levels of economic well-being. After all, an elderly person in a wheelchair would gladly change places with a young person who does not need a wheelchair, so the older person cannot be said to be economically better off than the younger person by the value of the wheelchair—even though that is what gross international statistical comparisons would imply.

  One of the usual ways of making international comparisons is to compare the total money value of outputs in one country versus another. However, this gets us into other complications created by official exchange rates between their respective currencies, which may or may not reflect the actual purchasing power of those currencies. Governments may set their official exchange rates anywhere they wish, but that does not mean that the actual purchasing power of the money will be whatever they say it is. Purchasing power depends on what sellers are willing to sell for a given amount of money. That is why there are black markets in foreign currencies, where unofficial money changers may offer more of the local currency for a dollar than the government specifies, when the official exchange rate overstates what the local currency is worth in the market.

  Country A may have more output per capita than Country B if we measure by official exchange rates, while it may be just the reverse if we measure by the purchasing power of the money. Surely we would say that Country B has the larger total value of output if it could purchase everything produced in country A and still have something left over. As in other cases, the problem is not with understanding the basic economics involved. The problem is with verbal confusion spread by politicians, the media and others trying to prove some point with statistics.

  Some have claimed, for example, that Japan has had a higher per capita income than the United States, using statistics based on official exchange rates of the dollar and the yen.{548} But, in fact, the average American’s annual income could buy everything the average Japanese annual income buys and still have thousands of dollars left over. Therefore the average American has a higher standard of living than the average Japanese.

  Yet statistics based on official exchange rates may show the average Japanese earning thousands of dollars more than the average American in some years, leaving the false impression that the Japanese are more prosperous than Americans. In reality, purchasing power per person in Japan is about 71 percent of that in the United States.{549}

  Another complication in comparisons of output between nations is that more of one nation’s output may have been sold through the marketplace, while more of the other nation’s output may have been produced by government and either given away or sold at less than its cost of production. When too many automobiles have been produced in a market economy to be sold profitably, the excess cars have to be sold for whatever price they can get, even if that is less than what it cost to produce them. When the value of national output is added up, these cars are counted according to what they sold for. But, in an economy where the government provides many free or subsidized goods, these goods are valued at what it cost the government to produce them.

  These ways of counting exaggerate the value of government-provided goods and services, many of which are provided by government precisely because they would never cover their costs of production if sold in a free market economy. Given this tendency to overvalue the output of socialist economies relative to capitalist economies when adding up their r
espective Gross Domestic Products, it is all the more striking that statistics still generally show higher output per capita in capitalist countries.

  Despite all the problems with comparisons of national output between very different countries or between time periods far removed from one another, Gross Domestic Product statistics provide a reasonable, though rough, basis for comparing similar countries at the same time—especially when population size differences are taken into account by comparing Gross Domestic Product per capita. Thus, when the data show that the Gross Domestic Product per capita in Norway in 2009 was more than double what it was in Italy that same year,{550} we can reasonably conclude that the Norwegians had a significantly higher standard of living. But we need not pretend to precision. As John Maynard Keynes said, “It is better to be roughly right than precisely wrong.”{551}

  Ideally, we would like to be able to measure people’s personal sense of well-being but that is impossible. The old saying that money cannot buy happiness is no doubt true. However, opinion polls around the world indicate some rough correlation between national prosperity and personal satisfaction.{552} Nevertheless, correlation is not causation, as statisticians often warn, and it is possible that some of the same factors which promote happiness—security and freedom, for example—also promote economic prosperity.

  Which statistics about national output are most valid depends on what our purpose is. If the purpose of an international comparison is to determine which countries have the largest total output—things that can be used for military, humanitarian, or other purposes—then that is very different from determining which countries have the highest standard of living. For example, in 2009 the countries with the five highest Gross Domestic Products, measured by purchasing power, were:

  1. United States

  2. China

  3. Japan

  4. India

  5. Germany{553}

  Although China had the second highest Gross Domestic Product in the world, it was by no means among the leaders in Gross Domestic Product per capita, since its output is divided among the largest population in the world. The Gross Domestic Product per capita in China in 2009 was in fact less than one-tenth that of Japan.{554}

  None of the countries with the five highest Gross Domestic Products were among those with the five highest GDP per capita, all of the latter being very small countries that were not necessarily comparable to the major nations that dominate the list of countries with the largest Gross Domestic Products. Some small countries like Bermuda are tax havens that attract the wealth of rich people from other countries, who may or may not become citizens while officially having a residence in the tax-haven country. But the fact that the Gross Domestic Product per capita of Bermuda is higher than that of the United States does not mean that the average permanent resident of Bermuda has a higher standard of living than the average American.

  Statistical Trends

  One of the problems with comparisons of national output over some span of time is the arbitrary choice of the year to use as the beginning of the time span. For example, one of the big political campaign issues of 1960 was the rate of growth of the American economy under the existing administration. Presidential candidate John F. Kennedy promised to “get America moving again” economically if he were elected, implying that the national economic growth rate had stagnated under the party of his opponent. The validity of this charge depended entirely on which year you chose as the year from which to begin counting. The long-term average annual rate of growth of the Gross National Product of the United States had been about 3 percent per year. As of 1960, this growth rate was as low as 1.9 percent (since 1945) or as high as 4.4 percent (since 1958).

  Whatever the influence of the existing administration on any of this, whether it looked like it was doing a wonderful job or a terrible job depended entirely on the base year arbitrarily selected.

  Many “trends” reported in the media or proclaimed in politics likewise depend entirely on which year has been chosen as the beginning of the trend. Crime in the United States has been going up if you measure from 1960 to the present, but down if you measure from 1990 to the present. The degree of income inequality was about the same in 1939 and 1999 but, in the latter year, you could have said that income inequality had increased from the 1980s onward because there were fluctuations in between the years in which it was about the same.{555} At the end of 2003, an investment in a Standard & Poor’s 500 mutual fund would have earned nearly a 10.5 percent annual rate of return (since 1963) or nearly a zero percent rate of return (since 1998).{556} It all depended on the base year chosen.

  Trends outside economics can be tricky to interpret as well. It has been claimed that automobile fatality rates have declined since the federal government began imposing various safety regulations. This is true—but it is also true that automobile fatality rates were declining for decades before the federal government imposed any safety regulations. Is the continuation of a trend that existed long before a given policy was begun proof of the effectiveness of that policy?

  In some countries, especially in the Third World, so much economic activity takes place “off the books” that official data on national output miss much—if not most—of the goods and services produced in the economy. In all countries, work done domestically and not paid for in wages and salary—cooking food, raising children, cleaning the home—goes uncounted. This inaccuracy does not directly affect trends over time if the same percentage of economic activity goes uncounted in one era as in another. In reality, however, domestic economic activities have undergone major changes over time in many countries, and vary greatly from one society to another at a given time.

  For example, as more women have entered the work force, many of the domestic chores formerly performed by wives and mothers without generating any income statistics are now performed for money by child care centers, home cleaning services and restaurants or pizza-delivery companies. Because money now formally changes hands in the marketplace, rather than informally between husband and wife in the home, today’s statistics count as output things that did not get counted before. This means that national output trends reflect not only real increases in the goods and services being produced, but also an increased counting of things that were not counted before, even though they existed before.

  The longer the time period being considered, the more the shifting of economic activities from the home to the marketplace makes the statistics not comparable. In centuries past, it was common for a family’s food to be grown in its own garden or on its own farm, and this food was often preserved in jars by the family rather than being bought from stores where it was preserved in cans. In 1791, Alexander Hamilton’s Report on Manufactures stated that four fifths of the clothing worn by the American people was homemade.{557} In pioneering times in America, or in some Third World countries today, the home itself might have been constructed by the family, perhaps with the help of friends and neighbors.

  As these and other economic activities moved from the family to the marketplace, the money paid for them made them part of official statistics. This makes it harder to know how much of the statistical trends in output over time represent real increases in totals and how much of these trends represent differences in how much has been recorded or has gone unrecorded.

  Just as national output statistics can overstate increases over time, they can also understate these increases. In very poor Third World countries, increasing prosperity can look statistically like stagnation. One of the ravages of extreme poverty is a high infant mortality rate, as well as health risks to others from inadequate food, shelter, medical services and sewage disposal. As Third World countries rise economically, one of the first consequences of higher income per capita is that more infants, small children, and frail old people are able to survive, now that they can afford better nutrition and medical care.

  This is particularly likely at the lower end of the income scale. But, with more poor people now surviving,
both absolutely and relative to the more prosperous classes, a higher percentage of the country’s population now consists of these poor people. Statistically, the averaging in of more poor people can understate the country’s average rise in real income, or can even make the average income decline statistically, even if every individual in the country has higher incomes than in the past.{xxv}

  Chapter 17

  MONEY AND

  THE BANKING SYSTEM

  A system established largely to prevent bank panics produced the most severe banking panic in American history.

  Milton Friedman{558}

  Money is of interest to most people but why should banking be of interest to anyone who is not a banker? Both money and banking play crucial roles in promoting the production of goods and services, on which everyone’s standard of living depends, and they are crucial factors in the ability of the economy as a whole to maintain full employment of its people and resources. While money is not wealth—otherwise the government could make us all twice as rich by simply printing twice as much money—a well-designed and well-maintained monetary system facilitates the production and distribution of wealth.

  The banking system plays a vital role in that process because of the vast amounts of real resources—raw materials, machines, labor—which are transferred by the use of money, and whose allocation is affected by the huge sums of money—trillions of dollars—that pass through the banking system. American banks had $14 trillion in assets in 2012, {559}for example. One way to visualize such a vast sum is that a trillion seconds ago, no one on this planet could read or write. Neither the Roman Empire nor the ancient Chinese dynasties had yet been formed and our ancestors lived in caves.