Basic Economics

by Sowell, Thomas

  In China, where the rate of savings is even higher than in India, 90 percent of those savings go into government-owned banks, where they are lent out at low interest rates, which in effect subsidize government-owned enterprises that typically have either low rates of return on the capital invested in them or are operating at a loss.{610} In short, most of China’s savings are not allocated to the most efficient and prosperous enterprises, which are in the private sector and may be foreign owned, but are sent to government-owned enterprises by government officials who run the banks.

  However much the situations in India and China differ from what is required for the efficient allocation of scarce resources which have alternative uses, it is very convenient for government officials. If private banks were allowed to operate freely in these countries, those banks would obviously lend or invest wherever they could safely get the highest rate of return on their money—which would be in firms and industries that were most prosperous. The private banks would then be able to offer higher interest rates to depositors, thereby attracting savings away from the state-run banks which are paying lower rates of interest.

  The net result would tend to be both higher rates of savings, in response to higher rates of interest paid on bank deposits, and the more efficient allocation of those savings to the more successful businesses, leading to higher rates of economic growth for the economy as a whole. But it would also create more headaches for government officials trying to keep government-run banks and government-run enterprises from going bankrupt. While economists might say that these inefficient enterprises should go out of business for the good of the economy, people with careers in government may be unlikely to be so willing to sustain damage to their own careers for the good of others.

  Government and Risk

  While banks manage money, what they must also manage is risk. Runs on banks are just one of those risks. Making loans that do not get repaid is a more common, if less visibly spectacular, risk. Either risk may not only inflict financial losses but can do so to the point of destroying the institution itself. As already noted, government can do things that either increase or decrease these risks.

  Insecure property rights are just one of the things within the control of government that has a major impact on the risks of banking. Because banks are almost invariably regulated by governments around the world, more so than other businesses, because of the potential impact of banking crises on the economy as a whole, the specific nature of that regulation can increase or decrease the riskiness of banking.

  One of the most prominent ways of reducing risk in the United States has been the government’s Federal Deposit Insurance Corporation. However, there was state deposit insurance before there was federal deposit insurance. These state deposit insurance laws were brought on by the increased risks that many states had created by forbidding banks from having branch offices. The purpose of outlawing branch banking was apparently to protect local banks from the competition of bigger and better-known banks headquartered elsewhere. The net effect of such laws made banks more risky because a bank’s depositors and borrowers were both concentrated wherever a particular bank’s one location might be.

  If this was in a wheat-growing area, for example, then a decline in the price of wheat in the world market could reduce the incomes of many of the bank’s depositors and borrowers at the same time, reducing both the deposits received and repayments on mortgages and other loans. State deposit insurance thus sought to deal with a risk created by state banking regulation. But state deposit insurance proved to be inadequate to its task. During the 1920s, and especially during the Great Depression of the 1930s, the thousands of American banks that failed were concentrated overwhelmingly in small communities in states with laws against branch banking.{611} Federal deposit insurance, created in 1935, put an end to ruinous bank runs, but it was solving a problem largely created by other government interventions.

  In Canada, not a single bank failed during the period when thousands of American banks were failing, even though the Canadian government did not provide bank deposit insurance during that era. But Canada had 10 banks with 3,000 branches from coast to coast.{612} That spread the risks of a given bank among many locations with different economic conditions. Large American banks with numerous branches likewise seldom failed, even during the Great Depression.

  Deposit insurance can create risks as well as reducing risk. People who are insured against risks—whether banking risks or risks to automobiles or homes, for example—may engage in more risky behavior than before, now that they have been insured. That is, they might park their car in a rougher neighborhood than they would take it to, if it were not insured against vandalism or theft. Or they might build a home in an area more vulnerable to hurricanes or wildfires than they would live in if they had no financial protection in the event that their home might be destroyed. Financial institutions have even more incentives to engage in risky behavior after having been insured, since riskier investments usually pay higher rates of return than safer investments.

  Government restrictions on the activities of banks insured by the Federal Deposit Insurance Corporation seek to minimize such risky investments. But containing the risk does not make the incentives for risk go away. Moreover, the government can misjudge some of the many risks that come and go, and so leave the taxpayers liable for losses that exceed the money collected from the banks as premiums paid for deposit insurance.

  As in China, India and other countries where government officials intervene to direct lending to borrowers favored by government officials, rather than to borrowers to whom bank officials were more likely to lend money otherwise, so in the United States the Community Reinvestment Act of 1977 sought to direct investment into low-income communities, including home mortgages for low or moderate income individuals.

  Although more or less dormant for years, the Community Reinvestment Act was re-invigorated during the 1990s in a push to make home-buying affordable to people whose low incomes, substandard credit history or lack of money for a 20 percent down payment made getting a mortgage loan approval unlikely. Under government pressures and threats, banks began to lower mortgage loan approval standards, in order to meet government goals or quotas. The net effect, in the United States as in other countries, was riskier lending and higher rates of default in the early twenty-first century.{613} This contributed to the collapse of banks and other lending institutions, as well as Wall Street firms whose mortgage-based assets’ value was ultimately dependent on the monthly mortgage payments that increasingly failed to materialize.

  Chapter 18

  GOVERNMENT FUNCTIONS

  The study of human institutions is always a search for the most tolerable imperfections.

  Richard A. Epstein{614}

  A modern market economy cannot exist in a vacuum. Market transactions take place within a framework of rules, and require someone with the authority to enforce those rules. Government not only enforces its own rules but also enforces contracts and other agreements and understandings among the numerous parties transacting with one another in the economy. Sometimes government also sets standards, defining what is a pound, a mile, or a bushel. In order to support itself, a government must also collect taxes, which in turn influence economic decision-making by those affected by those taxes.

  Beyond these basic functions, which virtually everyone can agree on, governments can play more expansive roles, all the way up to directly owning and operating all the farms and industries in a nation. Controversies have raged around the world, for more than a century, on the role that government should play in the economy. For much of the twentieth century, those who favored a larger role for government were clearly in the ascendancy, whether in democratic or undemocratic countries. The Soviet Union, China, and others in the Communist bloc of nations were at one extreme, but democratic countries like Britain, India, and France also had their governments take over ownership of various industries and tightly control the decisions made i
n other industries that were allowed to remain privately owned. Wide sections of the political, intellectual and even business communities have often been in favor of this expansive role of government.

  During the 1980s, however, the tide began to turn the other way, toward reducing the role of government. This happened first in Britain and the United States. Then such trends spread rapidly through the democratic countries, and even Communist China began to let markets operate more freely. The collapse of Communism in the Soviet bloc led to market economies emerging in Eastern Europe as well. As a 1998 study put it:

  All around the globe, socialists are embracing capitalism, governments are selling off companies they had previously nationalized, and countries are seeking to entice back multinational corporations that they had expelled just two decades earlier.{615}

  Experience—often bitter experience—had more to do with such changes than any new theory or analysis.

  Despite the wide range of functions which governments can engage in, and have engaged in, here we can examine the basic functions of government that virtually everyone can agree on and explain why those functions are important for the allocation of scarce resources which have alternative uses.

  One of the most basic functions of government is to provide a framework of law and order, within which the people can engage in whatever economic and other activities they choose, making such mutual accommodations and agreements among themselves as they see fit. There are also certain activities which generate significant costs or benefits that extend beyond those individuals who engage in those activities. Here government can take account of such costs and benefits when the marketplace does not.

  The individuals who work for government in various capacities tend to respond to the incentives facing them, just as people do in corporations, in families, and in other human institutions and activities. Government is neither a monolith nor simply the public interest personified. To understand what it does, its incentives and constraints must be taken into account, just as the incentives and constraints of the marketplace must be for those who engage in market transactions.

  LAW AND ORDER

  Where government restricts its economic role to that of an enforcer of laws and contracts, some people say that such a policy amounts to “doing nothing” as far as the economy is concerned. However, what is called “nothing” has often taken centuries to achieve—namely, a reliable framework of laws, within which economic activity can flourish, and without which even vast amounts of rich natural resources may fail to be developed into a corresponding level of output and resulting prosperity.

  Corruption

  Like the role of prices, the role of a reliable framework of laws may be easier to understand by observing what happens in times and places where such a framework does not exist. Countries whose governments are ineffectual, arbitrary, or thoroughly corrupt can remain poor despite an abundance of natural resources, because neither foreign nor domestic entrepreneurs want to risk the kinds of large investments which are required to develop natural resources into finished products that raise the general standard of living. A classic example is the African nation of Congo, rich in minerals but poor in every other way. Here is the scene encountered at the airport in its capital city of Kinshasa:

  Kinshasa is one of the world’s poorest cities, so unsafe for arriving crews that they get shuttled elsewhere for overnight stays. Taxiing down the scarred tarmac feels like driving over railroad ties. Managers charge extra to turn on the runway lights at night, and departing passengers can encounter several layers of bribes before boarding.{616}

  Bolivia is another Third World country where law and order have broken down:

  The media are full of revelations about police links to drug trafficking and stolen vehicles, nepotism in the force, and the charging of illegal fees for services. Officers on meagre salaries have been found to live in mansions.{617}

  In Egypt, when a rich and politically well-connected businessman was sentenced to death for hiring a hit man to kill a former lover, people were “astounded, and pleased,” according to the New York Times, because he was “a high roller of the type that Egyptians have long assumed to operate beyond the reach of the law.”{618}

  Whatever the merits or demerits of particular laws, someone must administer those laws—and how efficiently or how honestly that is done can make a huge economic difference. The phrase “the law’s delay” goes back at least as far as Shakespeare’s time. Such delay imposes costs on those whose investments are idled, whose shipments are held up, and whose ability to plan their economic activities is crippled by red tape and slow-moving bureaucrats. Moreover, bureaucrats’ ability to create delay often means an opportunity for them to collect bribes to speed things up—all of which adds up to higher costs of doing business. That in turn means higher prices to consumers, and correspondingly lower standards of living for the country as a whole.

  The costs of corruption are not limited to the bribes collected, since these are internal transfers, rather than net reductions of national wealth in themselves. Because scarce resources have alternative uses, the real costs are the foregone alternatives—delayed or aborted economic activity, the enterprises that are not started, the investments that are not made, the expansion of output and employment that does not take place in a thoroughly corrupt society, as well as the loss of skilled, educated, and entrepreneurial people who leave the country. As The Economist magazine put it: “For sound economic reasons, foreign investors and international aid agencies are increasingly taking the level of bribery and corruption into account in their investment and lending.” {619}

  A study by the World Bank concluded, “Across countries there is strong evidence that higher levels of corruption are associated with lower growth and lower levels of per capita income.”{620} The three countries ranked most corrupt were Haiti, Bangladesh, and Nigeria{621}—all poverty-stricken beyond anything seen in modern industrial societies.

  During czarist Russia’s industrialization in the late nineteenth and early twentieth centuries, one of the country’s biggest handicaps was the widespread corruption in the general population, in addition to the corruption that was rampant within the Russian government. Foreign firms that hired Russian workers, and even Russian executives, made it a point not to hire Russian accountants.{622} This corruption continued under the Communists and has become an international scandal in the post-Communist era. One study pointed out that the stock of a Russian oil company sold for about one percent of what the stock of a similar oil company would sell for in the United States, because “the market expects that Russian oil companies will be systematically looted by insiders.”{623} Similar corruption was common in Russian universities, according to The Chronicle of Higher Education’s Moscow correspondent:

  It costs between $10,000 and $15,000 in bribes merely to gain acceptance into well-regarded institutions of higher learning in Moscow, the daily newspaper Izvestia has reported. . . At Astrakhan State Technical University, about 700 miles south of Moscow, three professors were arrested after allegedly inducing students to pay cash to ensure good grades on exams. . . . Over all, Russian students and their parents annually spend at least $2 billion—and possibly up to $5 billion—in such “unofficial” educational outlays, the deputy prime minister, Valentina Matviyenko, said last year in an interview.{624}

  Corruption can of course take many forms besides the direct bribe. It can, for example, take the form of appointing politicians or their relatives to a company’s board of directors, in expectation of receiving more favorable treatment from the government. This practice varies from country to country, like more overt corruption. As The Economist put it, “politically linked firms are most common in countries famous for high levels of corruption.” Russia has led the way in this practice, in which firms with 80 percent of the country’s market capitalization were linked to public officials. The comparable figure for the United States was less than 10 percent, {625}partly due to American laws restr
icting this practice. Widespread corruption is not something new in Russia. John Stuart Mill wrote about it in the nineteenth century:

  The universal venality ascribed to Russian functionaries, must be an immense drag on the capabilities of economical improvement possessed so abundantly by the Russian empire: since the emoluments of public officers must depend on the success with which they can multiply vexations, for the purpose of being bought off by bribes.{626}

  It is not just corruption but also sheer bureaucracy which can stifle economic activity. Even one of India’s most spectacularly successful industrialists, Aditya Birla, found himself forced to look to other countries in which to expand his investments, because of India’s slow-moving bureaucrats:

  With all his successes, there were heartbreaks galore. One of them was the Mangalore refinery, which Delhi’s bureaucrats took eleven years to clear—a record even by the standards of the Indian bureaucracy. While both of us were waiting for a court to open up at the Bombay Gymkhana one day, I asked Aditya Birla what had led him to invest abroad. He had no choice, he said, in his deep, unaffected voice. There were too many obstacles in India. To begin with, he needed a license, which the government would not give because the Birlas were classified as “a large house” under the MRTP [Monopolies and Restrictive Trade Practices] Act. Even if he did get one miraculously, the government would decide where he should invest, what technology he must use, what was to be the size of his plant, how it was to be financed—even the size and structure of his public issue. Then he would have to battle the bureaucracy to get licenses for the import of capital goods and raw materials. After that, he faced dozens of clearances at the state level—for power, land, sales tax, excise, labor, among others. “All this takes years, and frankly, I get exhausted just thinking about it.”{627}