Basic Economics

by Sowell, Thomas

  Stock prices plummeted to a fraction of what they had been and American corporations as a whole operated at a loss for two years in a row. Unemployment, which had been 3 percent in 1929, rose to 25 percent in 1933.{534} It was the greatest economic catastrophe in the history of the United States. Moreover, the depression was not confined to the United States but was worldwide. In Germany, unemployment hit 34 percent in 1931, {535}setting the stage for the Nazis’ electoral triumph in 1932 that brought Hitler to power in 1933. Around the world, the fears, policies and institutions created during the Great Depression of the 1930s were still evident in the twenty-first century.

  THE FALLACY OF COMPOSITION

  While some of the same principles which apply when discussing markets for particular goods, industries, or occupations may also apply when discussing the national economy, it cannot be assumed in advance that this is always the case. When thinking about the national economy, a special challenge will be to avoid what philosophers call “the fallacy of composition”—the mistaken assumption that what applies to a part applies automatically to the whole. For example, the 1990s were dominated by news stories about massive reductions in employment in particular American firms and industries, with tens of thousands of workers being laid off by some large companies and hundreds of thousands in some industries. Yet the rate of unemployment in the U.S. economy as a whole was the lowest in years during the 1990s, while the number of jobs nationwide rose to record high levels.

  What was true of the various sectors of the economy that made news in the media was the opposite of what was true of the economy as a whole.

  Another example of the fallacy of composition would be adding up all individual investments to get the total investments of the country. When individuals buy government bonds, for example, that is an investment for those individuals. But, for the country as a whole, there are no more real investments—no more factories, office buildings, hydroelectric dams, etc.—than if those bonds had never been purchased. What the individuals have purchased is a right to sums of money to be collected from future taxpayers. These individuals’ additional assets are the taxpayers’ additional liabilities, which cancel out for the country as a whole.

  The fallacy of composition is not peculiar to economics. In a sports stadium, any given individual can see the game better by standing up but, if everybody stands up, everybody will not see better. In a burning building, any given individual can get out faster by running than by walking. But, if everybody runs, the stampede is likely to create bottlenecks at doors, preventing escapes by people struggling against one another to get out, causing some of those people to lose their lives needlessly in the fire. That is why there are fire drills, so that people will get in the habit of leaving during an emergency in an orderly way, so that more lives can be saved.

  What is at the heart of the fallacy of composition is that it ignores interactions among individuals, which can prevent what is true for one of them from being true for them all.

  Among the common economic examples of the fallacy of composition are attempts to “save jobs” in some industry threatened with higher unemployment for one reason or another. Any given firm or industry can always be rescued by a sufficiently large government intervention, whether in the form of subsidies, purchases of the firm’s or industry’s products by government agencies, or by other such means. The interaction that is ignored by those advocating such policies is that everything the government spends is taken from somebody else. The 10,000 jobs saved in the widget industry may be at the expense of 15,000 jobs lost elsewhere in the economy by the government’s taxing away the resources needed to keep those other people employed. The fallacy is not in believing that jobs can be saved in given industries or given sectors of the economy. The fallacy is in believing that these are net savings of jobs for the economy as a whole.

  OUTPUT AND DEMAND

  One of the most basic things to understand about the national economy is how much its total output adds up to. We also need to understand the important role of money in the national economy, which was so painfully demonstrated in the Great Depression of the 1930s. The government is almost always another major factor in the national economy, even though it may or may not be in particular industries. As in many other areas, the facts are relatively straightforward and not difficult to understand. What gets complicated are the misconceptions that have to be unravelled.

  One of the oldest confusions about national economies is reflected in fears that the growing abundance of output threatens to reach the point where it exceeds what the economy is capable of absorbing. If this were true, then masses of unsold goods would lead to permanent cutbacks in production, leading in turn to massive and enduring unemployment. Such an idea has appeared from time to time over more than two centuries, though usually not among economists. However, a Harvard economist of the mid-twentieth century named Seymour Harris seemed to express such views when he said: “Our private economy is faced with the tough problem of selling what it can produce.”{536} A popular best-selling author of the 1950s and 1960s named Vance Packard expressed similar worries about “a threatened overabundance of the staples and amenities and frills of life” which have become “a major national problem” for the United States.{537}

  President Franklin D. Roosevelt blamed the Great Depression of the 1930s on people of whom it could be said that “the products of their hands had exceeded the purchasing power of their pocketbooks.”{538} A widely used history textbook likewise explained the origins of the Great Depression of the 1930s this way:

  What caused the Great Depression? One basic explanation was overproduction by both farm and factory. Ironically, the depression of the 1930s was one of abundance, not want. It was the “great glut” or the “plague of plenty.”{539}

  Yet today’s output is several times what it was during the Great Depression, and many times what it was in the eighteenth and nineteenth centuries, when others expressed similar views. Why has this not created the problem that so many have feared for so long, the problem of insufficient income to buy the ever-growing output that has been produced?

  First of all, while income is usually measured in money, real income is measured by what that money can buy, how much real goods and services. The national output likewise consists of real goods and services. The total real income of everyone in the national economy and the total national output are one and the same thing. They do not simply happen to be equal at a given time or place. They are necessarily equal always because they are the same thing looked at from different angles—that is, from the standpoint of income and from the standpoint of output. The fear of a permanent barrier to economic growth, based on output exceeding real income, is as inherently groundless today as it was in past centuries when output was a small fraction of what it is today.

  What has lent an appearance of plausibility to the idea that total output can exceed total real income is the fact that both output and income fluctuate over time, sometimes disastrously, as in the Great Depression of the 1930s. At any given time, for any of a number of reasons, either consumers or businesses—or both—may hesitate to spend their income. Since everyone’s income depends on someone else’s spending, such hesitations can reduce aggregate money income and with it aggregate money demand. When various government policies generate uncertainty and apprehensions, this can lead individuals and businesses to want to hold on to their money until they see how things are going to turn out.

  When millions of people do this at the same time, that in itself can make things turn out badly because aggregate demand falls below aggregate income and aggregate output. An economy cannot continue producing at full capacity if people are no longer spending and investing at full capacity, so cutbacks in production and employment may follow until things sort themselves out. How such situations come about, how long it will take for things to sort themselves out, and what policies are best for coping with these problems are all things on which different schools of economists may di
sagree. However, what economists in general agree on is that this situation is very different from the situation feared by those who foresaw a national economy simply glutted by its own growing abundance because people lack the income to buy it all. What people may lack is the desire to spend or invest all their income.

  Simply saving part of their income will not necessarily reduce aggregate demand because the money that is put into banks or other financial institutions is in turn lent or invested elsewhere. That money is then spent by different people for different things but it is spent nonetheless, whether to buy homes, build factories, or otherwise. For aggregate demand to decline, either consumers or investors, or both, have to hesitate to part with their money, for one reason or another. That is when current national output cannot all be sold and producers cut back their production to a level that can be sold at prices that cover production costs. When this happens throughout the economy, national output declines and unemployment increases, since fewer workers are hired to produce a smaller output.

  During the Great Depression of the 1930s, some people saved their money at home in a jar or under a mattress, since thousands of bank failures had led them to distrust banks. This reduced aggregate demand, since this money that was saved was not invested.

  Some indication of the magnitude and duration of the Great Depression can be found in the fact that the 1929 level of output—$104 billion, in the dollars of that year—fell to $56 billion by 1933. Taking into account changes in the value of money during this era, the 1929 level of real output was not reached again until 1936.{540} For an economy to take seven years to get back to its previous level of output is extraordinary—one of the many extraordinary things about the Great Depression of the 1930s.

  MEASURING NATIONAL OUTPUT

  The distinction between income and wealth that was made when discussing individuals in Chapter 10 applies also when discussing the income and wealth of the nation as a whole. A country’s total wealth includes everything it has accumulated from the past. Its income or national output, however, is what is produced during the current year. Accumulated wealth and current output are both important, in different ways, for indicating how much is available for different purposes, such as maintaining or improving the people’s standard of living or for carrying out the functions of government, business, or other institutions.

  National output during a year can be measured in a number of ways. The most common measure today is the Gross Domestic Product (GDP), which is the sum total of everything produced within a nation’s borders. An older and related measure, the Gross National Product (GNP) is the sum total of all the goods and services produced by the country’s people, wherever they or their resources may be located. These two measures of national output are sufficiently similar that people who are not economists need not bother about the differences. For the United States, the difference between GDP and GNP has been less than one percent.

  The real distinction that must be made is between both these measures of national output during a given year—a flow of real income—versus the accumulated stock of wealth as of a given time.{xxiv} At any given time, a country can live beyond its current production by using up part of its accumulated stock of wealth from the past. During World War II, for example, American production of automobiles stopped, so that factories which normally produced cars could instead produce tanks, planes and other military equipment. This meant that existing cars simply deteriorated with age, without being replaced. So did most refrigerators, apartment buildings and other parts of the national stock of wealth. Wartime government posters said:

  Use it up,

  Wear it out,

  Make it do,

  Or do without.

  After the war was over, there was a tremendous increase in the production of cars, refrigerators, housing, and other parts of the nation’s accumulated stock of wealth which had been allowed to wear down or wear out while production was being devoted to urgent wartime purposes. The durable equipment of consumers declined in real value between 1944 and 1945, the last year of the war—and then more than doubled in real value over the next five years, as the nation’s stock of durable assets that had been depleted during the war was replenished.{541} This was an unprecedented rate of growth. Businesses as well had an accelerated growth of durable equipment after the war.

  Just as national income does not refer to money or other paper assets, so national wealth does not consist of these pieces of paper either, but of the real goods and services that money can buy. Otherwise, any country could get rich immediately just by printing more money. Sometimes national output or national wealth is added up by using the money prices of the moment, but most serious long-run studies measure output and wealth in real terms, taking into account price changes over time. This is necessarily an inexact process because the prices of different things change differently over time. In the century between 1900 and 2000, for example, the real cost of electricity, eggs, bicycles, and clothing all declined in the United States, while the real cost of bread, beer, potatoes, and cigarettes all rose.{542}

  The Changing Composition of Output

  Prices are not the only things that change over time. The real goods and services which make up the national output also change. The cars of 1950 were not the same as the cars of 2000. The older cars usually did not have air conditioning, seat belts, anti-lock brakes, or many other features that have been added over the years. So when we try to measure how much the production of automobiles has increased in real terms, a mere count of how many such vehicles there were in both time periods misses a huge qualitative difference in what we are arbitrarily defining as being the same thing—cars. A J.D. Power survey in 1997 found both cars and trucks to be the best they had ever tested.{543} Similarly, a 2003 report on sports utility vehicles by Consumer Reports magazine began:

  All five of the sport-utilities we tested for this report performed better overall than the best SUV of five years ago.{544}

  Housing has likewise changed qualitatively over time. The average American house at the end of the twentieth century was much larger, had more bathrooms, and was far more likely to have air conditioning and other amenities than houses which existed in the United States in the middle of that century. Merely counting how many houses there were at both times does not tell us how much the production of housing had increased. Just between 1983 and 2000, the median square feet in a new single-family house in the United States increased from 1,565 to 2,076.{545}

  While these are problems which can be left for professional economists and statisticians to try to wrestle with, it is important for others to at least be aware of such problems, so as not to be misled by politicians or media pundits who throw statistics around for one purpose or another. Just because the same word is used—a “car” or a “house”—does not mean that the same thing is being discussed.

  Over a period of generations, the goods and services which constitute national output change so much that statistical comparisons can become practically meaningless, because they are comparing apples and oranges. At the beginning of the twentieth century, the national output of the United States did not include any airplanes, television sets, computers or nuclear power plants. At the end of that century, American national output no longer included typewriters, slide rules (once essential for engineers, before there were pocket calculators), or a host of equipment and supplies once widely used in connection with horses that formerly provided the basic transportation of many societies around the world.

  What then, does it mean to say that the Gross Domestic Product was X percent more in the year 2000 than in 1900, when it consisted largely of very different things at these different times? It may mean something to say that output this year is 5 percent higher or 3 percent lower than it was last year because it consists of much the same things in both years. But the longer the time span involved, the more such statistics approach meaninglessness.

  A further complication in comparisons over time is that
attempts to measure real income depend on statistical adjustments which have a built-in inflationary bias. Money income is adjusted by taking into account the cost of living, which is measured by the cost of some collection of items commonly bought by most people. The problem with that approach is that what people buy is affected by price. When videocassette recorders were first produced, they sold for $30,000 each and were sold at luxury-oriented Neiman Marcus stores. Only many years later, after their prices had fallen below $200, were videocassette recorders so widely used that they were now included in the collection of items used to determine the cost of living, as measured by the consumer price index. But all the previous years of dramatically declining prices of videocassette recorders had no effect on the statistics used to compile the consumer price index.

  The same general pattern has occurred with innumerable other goods that went from being rare luxuries of the rich to common items used by most consumers, since it was only after becoming commonly purchased items that they began to be included in the collection of goods and services whose prices were used to determine the consumer price index.

  Thus, while many goods that are declining in price are not counted when measuring the cost of living, common goods that are increasing in price are measured. A further inflationary bias in the consumer price index or other measures of the cost of living is that many goods which are increasing in price are also increasing in quality, so that the higher prices do not necessarily reflect inflation, as they would if the prices of the same identical goods were rising. The practical—and political—effects of these biases can be seen in such assertions as the claim that the real wages of Americans have been declining for years. Real wages are simply money wages adjusted for the cost of living, as measured by the consumer price index. But if that index is biased upward, then that means that real wage statistics are biased downward.