Basic Economics

by Sowell, Thomas

  Although economists often proceed by first explaining how a free competitive market operates and then move on to show how various infringements on that kind of market affect economic outcomes, what happened in history is that controlled markets preceded free markets by centuries. Requirements for government permission to engage in various occupations were common centuries ago. The rise of free markets was aided by the rise and spread of classical economics in the nineteenth century. Although both product markets and labor markets became freer in the nineteenth century, the forces that sought protection from competition were never completely eradicated. Gradually, over the years, more occupations began to require licenses—a process accelerated in bad economic times, such as the Great Depression of the 1930s, or after government intervention in the economy began to become more accepted again.

  Although the rationale for requiring licenses in particular occupations has usually been to protect the public from various risks created by unqualified or unscrupulous practitioners, the demand for such protection has seldom come from the public. Almost invariably the demand for requiring a license has come from existing practitioners in the particular occupation. That the real goal is to protect themselves from competition is suggested by the fact that it is common for occupational licensing legislation to exempt existing practitioners, who are automatically licensed, as if it can be assumed that the public requires no protection from incompetent or dishonest practitioners already in the occupation.

  Occupational licensing can take many forms. In some cases, the license is automatically issued to all the applicants who can demonstrate competence in the particular occupation, with perhaps an additional requirement of a clean record as a law-abiding citizen. In other cases, there is a numerical limit placed on the number of licenses to be issued, regardless of how many qualified applicants there are. A common example of the latter is a license to drive a taxi. New York City, for example, has been limiting the number of taxi licenses since 1937, when it began issuing special medallions authorizing each taxi to operate. The resulting artificial scarcity of taxis has had many repercussions, the most obvious of which has been a rising cost of taxi medallions, which first sold for $10 in 1937, rising to $80,000 in the 1980s and selling for more than a million dollars in 2011.{430}

  PART IV:

  TIME AND RISK

  Chapter 13

  INVESTMENT

  A tourist in New York’s Greenwich Village decided to have his portrait sketched by a sidewalk artist. He received a very fine sketch, for which he was charged $100.

  “That’s expensive,” he said to the artist, “but I’ll pay it, because it is a great sketch. But, really, it took you only five minutes.”

  “Twenty years and five minutes,” the artist replied.

  Artistic ability is only one of many things which are accumulated over time for use later on. Some people may think of investment as simply a transaction with money. But, more broadly and more fundamentally, it is the sacrificing of real things today in order to have more real things in the future.

  In the case of the Greenwich Village artist, it was time that was invested for two decades, in order to develop the skills that allow a striking sketch to be made in five minutes. For society as a whole, investment is more likely to take the form of foregoing the production of some consumer goods today so that the labor and capital that would have been used to produce those consumer goods will be used instead to produce machinery and factories that will cause future production to be greater than it would be otherwise. The accompanying financial transactions may be what the attention of individual investors are focused on but here, as elsewhere, for society as a whole money is just an artificial device to facilitate real things that constitute real wealth.

  Because the future cannot be known in advance, investments necessarily involve risks, as well as the tangible things that are invested. These risks must be compensated if investments are to continue. The cost of keeping people alive while waiting for their artistic talent to develop, their oil explorations to finally find places where oil wells can be drilled, or their academic credits to eventually add up to enough to earn their degrees, are all investments that must be repaid if such investments are to continue to be made.

  The repaying of investments is not a matter of morality, but of economics. If the return on the investment is not enough to make it worthwhile, fewer people will make that particular investment in the future, and future consumers will therefore be denied the use of the goods and services that would otherwise have been produced.

  No one is under any obligation to make all investments pay off, but how many need to pay off, and to what extent, is determined by how many consumers value the benefits of other people’s investments, and to what extent.

  Where the consumers do not value what is being produced, the investment should not pay off. When people insist on specializing in a field for which there is little demand, their investment has been a waste of scarce resources that could have produced something else that others wanted. The low pay and sparse employment opportunities in that field are a compelling signal to them—and to others coming after them—to stop making such investments.

  The principles of investment are involved in activities that do not pass through the marketplace, and are not normally thought of as economic. Putting things away after you use them is an investment of time in the present to reduce the time required to find them in the future. Explaining yourself to others can be a time-consuming, and even unpleasant, activity but it is engaged in as an investment to prevent greater unhappiness in the future from avoidable misunderstandings.

  KINDS OF INVESTMENTS

  Investments take many forms, whether the investment is in human beings, steel mills, or transmission lines for electricity. Risk is an inseparable part of these investments and others. Among the ways of dealing with risk are speculation, insurance and the issuance of stocks and bonds.

  Human Capital

  While human capital can take many forms, there is a tendency of some to equate it with formal education. However, not only may many other valuable forms of human capital be overlooked this way, the value of formal schooling may be exaggerated and its counterproductive consequences in some cases not understood.

  The industrial revolution was not created by highly educated people but by people with practical industrial experience. The airplane was invented by a couple of bicycle mechanics who had never gone to college. Electricity and many inventions run by electricity became central parts of the modern world because of a man with only three months of formal schooling, Thomas Edison. Yet all these people had enormously valuable knowledge and insights—human capital—acquired from experience rather than in classrooms.

  Education has of course also made major contributions to economic development and rising standards of living. But this is not to say that all kinds of education have. From an economic standpoint, some education has great value, some has no value and some can even have a negative value. While it is easy to understand the great value of specific skills in medical science or engineering, for example, or the more general foundation for a number of professions provided by mathematics, other subjects such as literature make no pretense of producing marketable skills but are available for whatever they may contribute in other ways.

  In a country where education or higher levels of education are new or rare, those who have obtained diplomas or degrees may feel that many kinds of work are now beneath them. In such societies, even engineers may prefer sitting at a desk to standing in the mud in hip boots at a construction site. Depending on what they have studied, the newly educated may have higher levels of expectations than they have higher levels of ability to create the wealth from which their expectations can be met.

  In the Third World especially, those who are the first members of their families to reach higher education typically do not study difficult and demanding subjects like science, medicine, or engineering, but instead tend toward easier and fuzzi
er subjects which provide them with little in the way of marketable skills—which is to say, skills that can create prosperity for themselves or their country.

  Large numbers of young people with schooling, but without economically meaningful skills, have produced much unemployment in Third World nations. Since the marketplace has little to offer such people that would be commensurate with their expectations, governments have created swollen bureaucracies to hire them, in order to neutralize their potential for political disaffection, civil unrest or insurrection. In turn, these bureaucracies and the voluminous and time-consuming red tape they generate can become obstacles to others who do have the skills and entrepreneurship needed to contribute to the country’s economic advancement.

  In India, for example, two of its leading entrepreneurial families, the Tatas and the Birlas, have been repeatedly frustrated in their efforts to obtain the necessary government permission to expand their enterprises:

  The Tatas made 119 proposals between 1960 and 1989 to start new businesses or expand old ones, and all of them ended in the wastebaskets of the bureaucrats. Aditya Birla, the young and dynamic inheritor of the Birla empire, who had trained at MIT, was so disillusioned with Indian policy that he decided to expand Birla enterprises outside India, and eventually set up dynamic companies in Thailand, Malaysia, Indonesia, and the Philippines, away from the hostile atmosphere of his home.{431}

  The vast array of government rules in India, micro-managing businesses, “ensured that every businessman would break some law or the other every month,” according to an Indian executive.{432} Large businesses in India set up their own bureaucracies in Delhi, parallel to those of the government, in order to try to keep track of the progress of their applications for the innumerable government permissions required to do things that businesses do on their own in free market economies, and to pay bribes as necessary to secure these permissions.{433}

  The consequences of suffocating bureaucratic controls in India have been shown not only by such experiences while they were in full force but also by the country’s dramatic economic improvements after many of these controls were relaxed or eliminated. The Indian economy’s growth rate increased dramatically after reforms in 1991 freed many of its entrepreneurs from some of the worst controls, and foreign investment in India rose from $150 million to $3 billion{434}—in other words, by twenty times.

  Hostility to entrepreneurial minorities like the Chinese in Southeast Asia or the Lebanese in West Africa has been especially fierce among the newly educated indigenous people, who see their own diplomas and degrees bringing them much less economic reward than the earnings of minority business owners who may have less formal schooling than themselves.

  In short, more schooling is not automatically more human capital. It can in some cases reduce a country’s ability to use the human capital that it already possesses. Moreover, to the extent that some social groups specialize in different kinds of education, or have different levels of performance as students, or attend educational institutions of differing quality, the same number of years of schooling does not mean the same education in any economically meaningful sense. Such qualitative differences have in fact been common in countries around the world, whether comparing the Chinese and the Malays in Malaysia, Sephardic and Ashkenazic Jews in Israel, Tamils and Sinhalese in Sri Lanka or comparing various ethnic groups with one another in the United States.{435}

  Financial Investments

  When millions of people invest money, what they are doing more fundamentally is foregoing the use of current goods and services, which they have the money to buy, in hopes that they will receive back more money in the future—which is to say, that they may be able to receive a larger quantity of goods and services in the future. From the standpoint of the economy as a whole, investments mean that many resources that would otherwise have gone into producing current consumer goods like clothing, furniture, or pizzas will instead go into producing factories, ships or hydroelectric dams that will provide future goods and services. Money totals give us some idea of the magnitude of investments but the investments themselves are ultimately additions to the real capital of the country, whether physical capital or human capital.

  Investments may be made directly by individuals who buy corporate stock, for example, supplying corporations with money now in exchange for a share of the additional future value that these corporations are expected to add by using the money productively.

  Much investment, however, is by institutions such as banks, insurance companies, and pension funds. Financial institutions around the world owned a total of $60 trillion in investments in 2009, of which American institutions owned 45 percent.{436}

  The staggering sums of money owned by various investment institutions are often a result of aggregating individually modest sums of money from millions of people, such as stockholders in giant corporations, depositors in savings banks or workers who pay modest but regular amounts into pension funds. What this means is that vastly larger numbers of people are owners of giant corporations than those who are direct individual purchasers of corporate stock, as distinguished from those whose money makes its way into corporations through some financial intermediary. By the late twentieth century, just over half the American population owned stock, either directly or through their pension funds, bank accounts or other financial intermediaries.{437}

  Financial institutions allow vast numbers of individuals who cannot possibly all know each other personally to nevertheless use one another’s money by going through some intermediary institution which assumes the responsibility of assessing risks, taking precautions to reduce those risks, and making transfers through loans to individuals or institutions, or by making investments in businesses, real estate or other ventures.

  Financial intermediaries not only allow the pooling of money from innumerable individuals to finance huge economic undertakings by businesses, they also allow individuals to redistribute their own individual consumption over time. Borrowers in effect draw on future income to pay for current purchases, paying interest for the convenience. Conversely, savers postpone purchases till a later time, receiving interest for the delay.

  Everything depends on the changing circumstances of each individual’s life, with many—if not most—people being both debtors and creditors at different stages of their lives. People who are middle-aged, for example, tend to save more than young people, not only because their incomes are higher but also because of a need to prepare financially for retirement in the years ahead and for the higher medical expenses that old age can be expected to bring. In the United States, Canada, Britain, Italy, and Japan, the highest rates of saving have been in the 55 to 59 year old bracket and the lowest in the under 30 year old bracket—the whole under 30 cohort having zero net savings in Canada and negative net savings in the United States.{438} While those who are saving may not think of themselves as creditors, the money that they put into banks is then lent out by those banks, acting as intermediaries between those who are saving and those who are borrowing.

  What makes such activities something more than matters of personal finance is that these financial transactions are for the economy as a whole another way of allocating scarce resources which have alternative uses—allocating them over time, as well as among individuals and enterprises at a given time. To build a factory, a railroad, or a hydroelectric dam requires that labor, natural resources, and other factors of production that would otherwise go into producing consumer goods in the present be diverted to creating something that may take years before it begins to produce any output that can be used in the future.

  In short, from the standpoint of society as a whole, present goods and services are sacrificed for the sake of future goods and services. Only where those future goods and services are more valuable than the present goods and services that are being sacrificed will financial institutions be able to receive a rate of return on their investments that will allow them to offer a high enough rate of return to
innumerable individuals to induce those individuals to sacrifice their current consumption by supplying the savings required.

  With financial intermediaries as with other economic institutions, nothing shows their function more clearly than seeing what happens when they are not able to function. A society without well-functioning financial institutions has fewer opportunities to generate greater wealth over time. Poor countries may remain poor, despite having an abundance of natural resources, when they have not yet developed the complex financial institutions required to mobilize the scattered savings of innumerable individuals, so as to be able to make the large investments required to turn natural resources into usable output. Sometimes foreign investors from countries which do have such institutions are the only ones able to come in to perform this function. At other times, however, there is not the legal framework of dependable laws and secure property rights required for either domestic or foreign investors to function.

  Financial institutions not only transfer resources from one set of consumers to another and transfer resources from one use to another, they also create wealth by joining the entrepreneurial talents of people who lack money to the savings of many others, in order to finance new firms and new industries. Many, if not most, great American industries and individual fortunes began with entrepreneurs who had very limited financial resources at the outset. The Hewlett-Packard Corporation, for example, began as a business in a garage rented with borrowed money, and many other famous entrepreneurs—Henry Ford, Thomas Edison, and Andrew Carnegie, for example—had similarly modest beginnings. That these individuals and the enterprises they founded later became wealthy was an incidental by-product of the fact that they created vast amounts of wealth for the country as a whole. But the ability of poorer societies to follow similar paths is thwarted when they lack the financial institutions to allocate resources to those with great entrepreneurial ability but little or no money.