Basic Economics

by Thomas Sowell

  Local governments operate under much the same set of political incentives as national governments, so it is not surprising that employees of local governments, and of enterprises controlled or regulated by local governments, often have very generous pensions. Not only may employees of New York’s Long Island Rail Road, run by the Metropolitan Transportation Authority, retire in their fifties, the vast majority of these retirees also receive disability payments in addition to their pensions, even though most made no disability claims while working, but only after retiring. In 2007, for example, “94 percent of career employees who retired from the Long Island Rail Road after age 50 then received disability benefits,” according to the New York Times. Far from reflecting work hazards, these post-retirement disability claims are part of a whole web of arcane work rules under union contracts that permit employees to collect two days’ pay for one day’s work and permitted one engineer to collect “five times his base salary” one year and later be classified as disabled after retirement, according to the New York Times.{715}

  In Brazil, government pensions are already paying out more money than they are taking in, with the deficits being especially large in the pensions for unionized government employees. In other words, the looming financial crisis which American and European governments are dreading and trying to forestall has already struck in Brazil, whose government pensions have been described as “the most generous in the world.” According to The Economist:

  Civil servants do not merely retire on full salary; they get, in effect, a pay rise because they stop paying contributions into the system. Most women retire from government service at around 50 and men soon afterwards. A soldier’s widow inherits his pension, and bequeaths it to her daughters.{716}

  Given that Brazil’s civil servants are an organized and unionized special interest group, such generosity is understandable politically. The question is whether the voting public in Brazil and elsewhere will understand the economic consequences well enough to be able to avoid the financial crises to which such unfunded generosity can lead—in the name of “social insurance.” Such awareness is beginning to dawn on people in some countries. In New Zealand, for example, a poll found that 70 percent of New Zealanders under the age of 45 believe that the pensions they have been promised will not be there for them when they retire.{717}

  In one way or another, the day of reckoning seems to be approaching in many countries for programs described as “social insurance” but which were in fact never insurance at all. Such programs not only fail to create wealth, the more generous retirement plans may in fact lessen the rate at which wealth is created, by enabling people to retire while they are still quite capable of working and thus adding to the nation’s output. For example, while 62 percent of the people in the 55 to 64 year old bracket in Japan are still working and 60 percent in the United States, only 41 percent of the people in that age bracket are still working in the countries of the European Union.{718}

  It is not just the age at which people retire that varies from country to country. How much their pensions pay, compared to how much they made while working, also varies greatly from one country to another. While pensions in the United States pay about 40 percent of pre-retirement earnings and those in Japan less than 40 percent, pensions in the Netherlands and Spain pay about 80 percent and, in Greece, 96 percent.{719} No doubt that has something to do with when people choose to stop working. It also has something to do with the financial crises that struck some European Union countries in the early twenty-first century.

  While the United States has long lagged behind European industrial nations in government-provided or government-mandated benefits, it has in more recent years been increasing such benefits rapidly. Unemployment insurance benefits, which used to end after 26 weeks in the United States, have been extended to 99 weeks. Other alternatives to working have also increased in their utilization—disability pay under Social Security “insurance,” for example:

  Barely three million Americans received work-related disability checks from Social Security in 1990, a number that had changed only modestly in the preceding decade or two. Since then, the number of people drawing disability checks has soared, passing five million by 2000, 6.5 million by 2005, and rising to nearly 8.6 million today.{720}

  MARKET FAILURE

  AND GOVERNMENT FAILURE

  The imperfections of the marketplace—including such things as external costs and benefits, as well as monopolies and cartels—have led many to see government interventions as necessary and beneficial. Yet the imperfections of the market must be weighed against the imperfections of the government whose interventions are prescribed. Both markets and governments must be examined in terms of their incentives and constraints.

  The incentives facing government enterprises tend to result in very different ways of carrying out their functions, compared to the way things are done in a free market economy. After banks were nationalized in India in 1969, for example, uncollectible debts rose to become 20 percent of all loans outstanding. Efficiency also suffered: An Indian entrepreneur reported that “it takes my wife half an hour to make a deposit or withdraw money from our local branch.” Moreover, government ownership and control led to political influence in deciding to whom bank loans were to be made:

  I once chanced to meet the manager of one of the rural branches of a nationalized bank. . . He was a sincere young man, deeply concerned, and he wanted to unburden himself about his day-to-day problems. Neither he nor his staff, he told me, decided who qualified for a loan. The local politicians invariably made this decision. The loan takers were invariably cronies of the political bosses and did not intend to repay the money. He was told that such and such a person was to be treated as a “deserving poor.” Without exception, they were rich.{721}

  The nationalization of banks in India was not simply a matter of transferring ownership of an enterprise to the government. This transfer changed all the incentives and constraints from those of the marketplace to those of politics and bureaucracy. The proclaimed goals, or even the sincere hopes, of those who created this transfer often turned out to mean much less than the changed incentives and constraints. These incentives and constraints were changed again after India began to allow private banks to operate. As the Wall Street Journal reported, “the country’s growing middle class is taking most of its business to the high-tech private banks,” thereby “leaving the state banks with the least-profitable businesses and worst borrowers.”{722} The people in the private sector may not have been much different from those in government but they operated under very different incentives and constraints.

  In the United States, political control of banks’ investment decisions has been less pervasive but has nevertheless changed the directions that investments have taken from what they would take in a free market. As the Wall Street Journal reported:

  Regulators whose approval is needed for mergers are taking a harder line on banks’ and savings-and-loans’ performance under the Community Reinvestment Act, a law that requires them to lend in every community where they take deposits. A weak lending record can slow or even derail a deal, while a strong one can speed approval and head off protests by community groups.{723}

  In other words, people with neither expertise nor experience in financial institutions—politicians, bureaucrats, and community activists—are enabled to influence where investments are to go. Yet, when financial institutions began to have huge losses in 2007 and 2008 on “subprime” loans—Citigroup losing more than $40 billion{724}—politicians were seldom blamed for having pushed these institutions to lend to people whose credit was below par. On the contrary, precisely those same politicians who had been most prominent in pushing lenders to take chances were now most prominent in fashioning “solutions” to the resulting crises, based on their experience on Congressional banking committees and therefore presumed expertise in dealing with financial matters.

  As an entrepreneur in India put it: “Indians have learned
from painful experience that the state does not work on behalf of the people. More often than not, it works on behalf of itself.”{725} So do people in other walks of life and in other countries around the world. The problem is that this fact is not always recognized when people look to government to right wrongs and fulfill desires to an extent that may not always be possible.

  Whatever the merits or demerits of particular government economic policies, the market alternative is very new as history is measured, and the combination of democracy and a free market still newer and rarer. As an observer in India put it:

  We tend to forget that liberal democracy based on free markets is a relatively new idea in human history. In 1776 there was one liberal democracy—the United States; in 1790 there were 3, including France; in 1848 there were only 5; in 1975 there were still only 31. Today 120 of the world’s 200 or so states claim to be democracies, with more than 50 percent of the world’s population residing in them (although Freedom House, an American think tank, counts only 86 countries as truly free).{726}

  Where there are elected governments, their officials must be concerned about being re-elected—which is to say that mistakes cannot be admitted and reversed as readily as they must be by a private business operating in a competitive market, in order for the business to survive financially. No one likes to admit being mistaken but, under the incentives and constraints of profit and loss, there is often no choice but to reverse course before financial losses threaten bankruptcy. In politics, however, the costs of the government’s mistakes are often paid by the taxpayers, while the costs of admitting mistakes are paid by elected officials.

  Given these incentives and constraints, the reluctance of government officials to admit mistakes and reverse course is perfectly rational from those officials’ standpoint. For example, when supersonic passenger jet planes were first contemplated, by both private plane manufacturers like Boeing and by the British and French governments who proposed building the Concorde, it became clear early on that the costs of fuel-guzzling supersonic passenger jets would be so high that there would be little hope of recovering those costs from fares that passengers would be willing to pay. Boeing dropped the whole idea, absorbing the losses of its early efforts as a lesser evil than continuing on and absorbing even bigger losses by completing the project. But the British and French governments, once publicly committed to the idea of the Concorde, continued on instead of admitting that it was a bad idea.

  The net result was that British and French taxpayers for years subsidized a commercial venture used largely by very affluent passengers, because fares on the Concorde were far higher than fares on other jets flying the same routes, even though these very expensive fares still did not fully cover the costs. Eventually, as Concordes aged, the plane was discontinued because its huge losses were now so widely known that it would have been politically difficult, if not impossible, to get public support for more government spending to replace planes that had never been economically viable.

  Although we often speak of “the government” as if it were a single thing, it is not only fragmented into differing and contending interests at any given time, its leadership consists of entirely different people over time. Thus those who put an end to the costly Concorde experiment were not the same as those who had launched this experiment in the first place. It is always easier to admit someone else’s mistakes—and to take credit for correcting them.

  In a competitive market, by contrast, the costs of mistakes can quickly become so high that there is no choice but to admit one’s own mistakes and change course before bankruptcy looms on the horizon. Because the day of reckoning comes earlier in markets than in government, there is not only more pressure to admit mistakes in the private sector, there is more pressure to avoid making mistakes in the first place. When proposals for new ventures are made in these different sectors, proposals made by government officials need only persuade enough people, in order to be successful within the time horizon that matters to those officials—usually the time until the next election. In a competitive market, however, proposals must convince those particular people whose own money is at stake and who therefore have every incentive to marshal the best available expertise to assess the future before proceeding.

  It is hardly surprising that these two processes can produce very different conclusions about the very same situations. Thus when the proposal for building a tunnel under the English Channel was being considered, the British and French governments projected costs and earnings that made it look like a good investment, at least to enough of the British and French public to make the venture politically viable. Meanwhile, companies running ferry service across the English Channel obviously thought otherwise, for they proceeded to invest in more and bigger ferries, which could have been financial suicide if the tunnel under the channel had turned out to be the kind of success that was projected by political officials, for that would lead people to take the underwater route across the channel, instead of ferries.

  Only after years of building and more years of operation did the economic outcome of the tunnel project become clear—and the British and French officials initially responsible for this venture were long gone from the political scene by then. In 2004 The Economist reported:

  “Without a doubt, the Channel Tunnel would not have been built if we’d known about these problems,” Richard Shirrefs, the chief executive of Eurotunnel, said this week. Too few people are using the ten-year-old undersea link between Britain and France to repay even the interest on its bloated construction costs, which have left Eurotunnel with [$11.5 billion] in debt. So, just as happened with supersonic Concorde, taxpayers are being asked to bail out another Anglo-French transport fiasco. . . . None of this will come as a surprise to tunnel-sceptics—who, like Concorde’s, were mostly ignored.{727}

  While these examples involved the British and French governments, similar incentives and constraints—and similar results—apply to many governments around the world.

  Sometimes, however, the short memory of the voting public can spare elected officials the consequences of having advocated a policy that has either failed or has quietly been abandoned. For example, in the United States, both individual states and the federal government have imposed gasoline taxes dedicated to the building and maintenance of highways—and both have later diverted these taxes to other things. In 2008, Congress passed a bill to spend hundreds of billions of dollars for the purpose of preventing financial institutions from collapsing. Yet, before the year was out, those Treasury Department officials in charge of dispersing this money openly admitted that much of it was diverted to bailing out other firms in other industries.

  None of this is new or peculiar to the United States. As far back as 1776, Adam Smith warned that a fund set aside by the British government for paying off the national debt was “an obvious and easy expedient” to be “misapplied” to other purposes.{728}

  PART VI:

  THE INTERNATIONAL ECONOMY

  Chapter 21

  INTERNATIONAL TRADE

  Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passions, they cannot alter the state of facts and evidence.

  John Adams{729}

  When discussing the historic North American Free Trade Agreement of 1993 (NAFTA), the New York Times said:

  Abundant evidence is emerging that jobs are shifting across borders too rapidly to declare the United States a job winner or a job loser from the trade agreement.{730}

  Posing the issue in these terms committed the central fallacy in many discussions of international trade—assuming that one country must be a “loser” if the other country is a “winner.” But international trade is not a zero-sum contest. Both sides must gain or it would make no sense to continue trading. Nor is it necessary for experts or government officials to determine whether both sides are gaining. Most international trade, like most domestic trade, is done by millions of individuals, each of whom can deter
mine whether the item purchased is worth what it cost and is preferable to what is available from others.

  As for jobs, before the NAFTA free-trade agreement among the United States, Canada, and Mexico went into effect, there were dire predictions of “a giant sucking sound” as jobs would be sucked out of the United States to Mexico because of Mexico’s lower wage rates. In reality, the number of American jobs increased after the agreement, and the unemployment rate in the United States fell over the next seven years from more than seven percent down to four percent, {731}the lowest level seen in decades. In Canada, the unemployment rate fell from 11 percent to 7 percent over the same seven years. {732}

  Why was what happened so radically different from what was predicted? Let’s go back to square one. What happens when a given country, in isolation, becomes more prosperous? It tends to buy more because it has more to buy with. And what happens when it buys more? There are more jobs created for workers producing the additional goods and services.

  Make that two countries and the principle remains the same. Indeed, make it any number of countries and the principle remains the same. Rising prosperity usually means rising employment.

  There is no fixed number of jobs that countries must fight over. When countries become more prosperous, they all tend to create more jobs. The only question is whether international trade tends to make countries more prosperous.