Basic Economics

by Sowell, Thomas

  The simultaneous rise of unemployment and inflation during the 1970s dealt a blow to Keynesian economics in general and to the idea that the government could fine-tune the economy in particular. Milton Friedman expressed a view that was the direct opposite of that expressed earlier by Walter Heller:

  A major problem of our time is that people have come to expect policies to produce results that they are incapable of producing. . . . we economists in recent years have done vast harm—to society at large and to our profession in particular—by claiming more than we can deliver. We have thereby encouraged politicians to make extravagant promises, inculcate unrealistic expectations in the public at large, and promote discontent with reasonably satisfactory results because they fall short of the economists’ promised land.{1030}

  Chapter 27

  PARTING THOUGHTS

  We shall not grow wiser before we learn that much that we have done was very foolish.

  F. A. Hayek{1031}

  Sometimes the whole is greater than the sum of its parts. In addition to whatever you may have learned in the course of this book about particular things such as prices, investment, or international trade, you may also have acquired a more general skepticism about many of the glittering words and fuzzy phrases that are mass produced by the media, by politicians and by others.

  You may no longer be as ready to uncritically accept statements and statistics about “the rich” and “the poor.” Nor should you find it mysterious that so many places with rent control laws have also had housing shortages, or that attempts to control the price of food have often led to hunger or even starvation.

  However, no listing of economic fallacies can be complete, because the fertility of the human imagination is virtually unlimited. New fallacies are being conceived, or misconceived, while the old ones are still being refuted. The most that can be hoped for is to reveal some of the more common fallacies and promote both skepticism and an analytical approach that goes beyond the emotional appeals which sustain so many harmful and even dangerous economic fallacies in politics and in the media.

  This should include a more careful use and definition of words, so that statements about how countries with high wages cannot compete in international trade with countries which have low wages do not escape scrutiny because of confusing high wage rates per unit of time with high labor costs per unit of output. Similar confusion between tax rates per dollar of income and total tax revenues received by the government has often made rational discussion of tax policies virtually impossible.

  Many economic fallacies depend upon (1) thinking of the economy as a set of zero-sum transactions, (2) ignoring the role of competition in the marketplace, or (3) not thinking beyond the initial consequences of particular policies.

  If economic transactions could benefit one party to those transactions only at the expense of the other party, then it would be understandable to believe that government intervention to change the transactions terms would produce a net benefit to a particular party, such as tenants or employees. But, if economic transactions benefit both parties, then changing the transactions terms to favor one side tends to reduce the number of transactions that the other side is willing to engage in. In a world of positive-sum transactions, it is understandable why rent control laws lead to housing shortages and minimum wage laws increase unemployment. Few people are likely to explicitly say that economic transactions benefit only one party to those transactions, but many fallacies persist because of implicit assumptions that people do not bother to spell out, even to themselves.

  Seldom do people think things through foolishly. More often, they do not bother to think things through at all, so that even highly intelligent individuals can reach untenable conclusions because their brainpower means little if it is not deployed and applied.

  The central role that competition plays in free market economies often gets overlooked by those who do not spell out their assumptions. One of the attractions of central planning, especially before it was put into operation and its consequences experienced, was that the alternative seemed to be a chaos of uncoordinated activity in an uncontrolled market.

  Many have also believed that labor unions can increase labor’s share of an industry’s income simply by reducing the share going to investors in that industry. But this ignores the competition for investment, which is attracted to industries where the returns are higher and repelled from industries where it is lower, thereby changing employment prospects in both places. Where there is competition between unionized and non-union companies in the same industry, as in American automobile manufacturing, it is hardly surprising to see General Motors drastically reducing the number of workers on its payroll while Toyota is increasing its hiring in the United States.

  Not thinking beyond the initial consequences of economic decisions, including government policies, is a special example of not bothering to think things through. Restricting the importation of foreign steel into the United States did indeed save jobs in the domestic steel industry, but its repercussions on the prices and sales of other domestic products made with higher-priced domestic steel cost far more jobs than those that were saved in the steel industry. None of this is rocket science but it does require stopping to think. The particular examples here or elsewhere in this book are not nearly as important as keeping in mind the economic principles they illustrate.

  Much confusion comes from judging economic policies by the goals they proclaim rather than the incentives they create. In wartime, for example, when military forces absorb many resources that would normally go into producing civilian products, there is often an understandable desire to ensure that such basic things as food continue to be available to the civilian population, especially those with low incomes. Thus price controls may be imposed on bread and butter, but not on champagne and caviar. However right this might seem, when you look only at the goal or the initial consequences, the picture changes drastically when you follow the subsequent repercussions from the incentives created.

  If the prices of bread and butter are kept lower than they would be if determined by supply and demand in a free market, then producers of bread and butter tend to end up with lower rates of profit than producers of champagne and caviar, who remain free to charge “whatever the traffic will bear,” since no one regards these things as essential. However, because all producers compete for labor and other scarce resources, this means that the higher profits from champagne and caviar enable their producers to bid away more resources, at the expense of producers of bread and butter, than they would have been able to in a free market without price controls. Shifting resources from the production of bread and butter to the production of champagne and caviar is one of the repercussions that escapes notice when we fail to think beyond the initial stage of consequences of economic policies. For similar reasons, rent control tends to shift resources from the production of ordinary housing for moderate-income people toward the building of luxury housing for the affluent and wealthy.

  The importance of economic principles extends beyond things that most people think of as economics. For example, those who worry about the exhaustion of petroleum, iron ore, or other natural resources often assume that they are discussing the amount of physical stuff on the planet. But that assumption changes radically when you realize that statistics on “known reserves” of these resources may tell us more about costs of exploration, and about the interest rate on the money that finances this exploration, than about how much of the resource remains on Earth. Nor is the amount of physical stuff necessarily what matters, without knowing how much of it can be extracted and processed at what costs.

  Many other decisions that are not usually thought of as economic, may in fact have serious economic repercussions. For example, some communities may decide to restrict how tall local buildings will be allowed to be built, without any thought that this has economic implications which can result in much higher rents being charged. {l} These are just some of a whole range of problems a
nd issues which, on the surface, might not seem to be economic matters, but which nevertheless look very different after understanding basic economic principles and applying them.

  The importance of the distinction between policy goals versus the incentives created by those policies extends beyond the particular things discussed in this book—and, indeed, beyond economics. Nothing is easier than to proclaim a wonderful goal. The “Law to Relieve the Distress of the People and Reich” during the Great Depression of the 1930s gave dictatorial powers to Adolf Hitler, leading to World War II, which created more distress and disaster than the German people—and many other peoples—had ever experienced before.

  What must be asked about any goal is: What specific things are going to be done in the name of that goal? What does the particular legislation or policy reward and what does it punish? What constraints does it impose? Looking to the future, what are the likely consequences of such incentives and constraints? Looking back at the past, what have been the consequences of similar incentives and constraints in other times and places? As the distinguished British historian Paul Johnson put it:

  The study of history is a powerful antidote to contemporary arrogance. It is humbling to discover how many of our glib assumptions, which seem to us novel and plausible, have been tested before, not once but many times and in innumerable guises; and discovered to be, at great human cost, wholly false.{1032}

  We have seen some of those great human costs—people going hungry in Russia, despite some of the richest farmland on the continent of Europe, people sleeping on cold sidewalks during winter nights in New York, despite far more boarded-up housing units in the city than it would take to shelter them all.

  Some of the economic policies which have led to counterproductive or even catastrophic consequences in various countries and in various periods of history might suggest that there was unbelievable stupidity on the part of those making these decisions—which, in democratic countries, might also imply unbelievable stupidity on the part of those who voted for them. But this is not necessarily so. While the economic analysis required to understand these issues may not be particularly difficult to grasp, one must first stop and think about the issues in an economic framework. When people do not stop and think through the issues, it does not matter whether those people are geniuses or morons, because the quality of the thinking that they would have done is a moot point.

  In addition to the role of incentives and constraints, one of our other central themes has been the role of knowledge. In free market economies, we have seen giant multi-billion-dollar corporations fall from their pinnacles, some all the way to bankruptcy and extinction, because their knowledge of changing circumstances, and the implications of those changes, lagged behind that of upstart rivals.

  While facts are important, understanding the implications of those facts is even more important, and that is what an understanding of economics seeks to provide. For example, the Eastman Kodak Company was the international colossus of the photographic industry for more than a century—and yet it was devastated economically by the rise of digital cameras, which destroyed the market for many Kodak products built around the now obsolete technology of film. Yet what Kodak lacked was not knowledge of digital cameras, which were invented by Kodak, but a failure to see the implications of this radically new technology as well as other companies which developed the potentialities of this technology to the point where Eastman Kodak was forced into bankruptcy. These other companies included not only traditional camera makers like Nikon and Canon but also companies outside the photographic industry, like Sony and Samsung, which began producing digital cameras.

  What is important is not that particular companies succumbed to competing companies, whether in the photographic industry or elsewhere, but that knowledge and insights proved decisive in market competition. The public benefitted because some business decisions were based on a clearer understanding of the economic realities of the times and circumstances—and these were the businesses that survived to use scarce resources that had alternative uses.

  In centrally planned economies, we have seen the planners overwhelmed by the task of trying to set literally millions of prices—and keep changing those prices in response to innumerable and often unforeseeable changes in circumstances. It was not remarkable that they failed so often. What was remarkable was that anyone had expected them to succeed, given the vast amount of knowledge that would have had to be marshaled and mastered in one place by one set of people at one time, in order to make such an arrangement work. Lenin was only one of many theorists over the centuries who imagined that it would be easy for government officials to run economic activities—and the first to encounter directly the economic and social catastrophes to which that belief led, as he himself admitted, after just a few years in power.

  Given the decisive advantages of knowledge and insight in a market economy, even when this knowledge and insight are in the minds of people born and raised in poverty, such as J.C. Penney or F.W. Woolworth, we can see why market economies have so often outperformed other economies that depend on ideas originating solely within a narrow elite of birth or ideology. While market economies are often thought of as money economies, they are still more so knowledge economies, for money can always be found to back new insights, technologies and organizational methods that work, even when these innovations were created by people initially lacking in money, whether Henry Ford, Thomas Edison, David Packard, or others. Capital is always available under capitalism, but knowledge and insights are rare and precious under any economic system.

  Knowledge should not be narrowly conceived as the kind of information in which intellectuals and academics specialize. We should not be like the depiction of the famous scholar Benjamin Jowett, master of Balliol College at Oxford, who inspired this verse:

  My name is Benjamin Jowett.

  If it’s knowledge, I know it.

  I am the master of this college,

  What I don’t know isn’t knowledge.

  In reality, there is much that the intelligentsia do not know that is knowledge vital to the functioning of an economy. It may be easy to disdain the kinds of highly specific mundane knowledge and its implications which are often economically decisive by asking, for example: “How much knowledge does it take to fry a hamburger?” Yet McDonald’s did not become a multi-billion-dollar corporation, with thousands of outlets around the world, for no reason—not with so many rivals trying desperately and unsuccessfully to do the same thing, and some of them failing even to make enough money to stay in business. Anyone who studies the history of this franchise chain {li} will be astonished at the amount of detailed knowledge, insights, organizational and technological innovation, financial improvisation, all-out efforts and desperate sacrifices that went into creating an enormous economic success from selling just a few common food products.

  Nor was McDonald’s unique. All sorts of businesses—from Sears to Intel and from Honda to the Bank of America—had to struggle upward from humble beginnings to ultimately achieve wealth and security. In all these cases, it was the knowledge and insight that was built up over the years—the human capital—which ultimately attracted the financial capital to make ideas become a reality. The other side of this is that, in countries where the mobilization of financial resources is made difficult by unreliable property rights laws, those at the bottom have fewer ways of getting the capital needed to back their entrepreneurial endeavors. More important, the whole society loses the benefits it could gain from what these stifled entrepreneurs could have contributed to the economic rise of the nation.

  Success is only part of the story of a free market economy. Failure is at least as important a part, though few want to talk about it and none want to experience it. When the same resources—whether land, labor or petroleum—can be used by different firms and different industries to produce different products, the only way for the successful ideas to become realities is to take resources away from other uses that tu
rn out to be unsuccessful, or which have become obsolete after having had their era of success. Economics is not about “win-win” options, but about often painful choices in the allocation of scarce resources which have alternative uses. Success and failure are not isolated good fortunes and misfortunes, but inseparable parts of the same process.

  All economies—whether capitalism, socialism, feudalism or whatever—are essentially ways of cooperating in the production and distribution of goods and services, whether this is done efficiently or inefficiently, voluntarily or involuntarily. Naturally, individuals and groups want their own particular contributions to the process to be better rewarded, but their complaints or struggles over this are a sideshow to the main event of complementary efforts which produce the output on which all depend. Yet invidious comparisons and internecine struggles are the stuff of social melodrama, which in turn is the lifeblood of the media and politics, as well as portions of the intelligentsia.

  By portraying cooperative activities as if they were zero-sum contests—whether in employer-employee relations or in international trade or other cooperative endeavors—those with the power to impose their misconceptions on others through words or laws can create a negative-sum contest, in which all are worse off. A young worker who is destitute of both knowledge and money would today find it virtually impossible to purchase the knowledge that was vital to a future career by working long hours for no pay, as many did in times past—including F. W. Woolworth, who by this means rose from dire poverty to become one of the richest men of his era in retailing.

  Those with a zero-sum vision who have seen property rights as mere special privileges for the affluent and the rich have helped erode or destroy such rights, or have made them practically inaccessible to the poor in Third World countries, thereby depriving the poor of one of the mechanisms by which people from backgrounds like theirs have risen to prosperity in other times and places.