Sowell_Thomas_-_Basic_Economics_-_5th_Edition_2014

maintenance of their bus fleet, 99 percent of the public might still be unaware ofthis or its long-run consequences. But among the other one percent who wouldbe far more likely to be aware would be those in charge of financial institutionsthat owned stock in the bus company, or were considering buying that stock orlending money to the bus company. For these investors, potential investors, orlenders examining financial records, the company’s present value would be seenas reduced, long before the first bus wore out. As in other situations, a market economy allows accurate knowledge to beeffective in influencing decision-making, even if 99 percent of the population donot have that knowledge. In politics, however, the 99 percent who do notunderstand can create immediate political success for elected officials and forpolicies that will turn out in the end to be harmful to society as a whole. It wouldof course be unreasonable to expect the general public to become financialexperts or any other kind of experts, since there are only 24 hours in the day andpeople have lives to lead. What may be more reasonable is to expect enoughvoters to see the dangers in letting many economic decisions be made throughpolitical processes. Time can turn economies of scale from an economic advantage to a politicalliability. After a business has made a huge investment in a fixed installation—agigantic automobile factory, a hydroelectric dam or a skyscraper, for example—the fact that this asset cannot be moved makes it a tempting target for high localtaxation or for the unionization of employees who can shut it down with a strikeand impose huge losses unless their demands are met. Where labor costs are asmall fraction of the total costs of an enterprise with a huge capital investment,even a doubling of wages may be a price worth paying to keep a multi-billion-dollar operation going. This does not mean that investors will simply accept apermanently reduced rate of return in this company or industry. As in otheraspects of an economy, a change in one factor has repercussions elsewhere. While a factory or dam cannot be moved, an office staff—even theheadquarters staff of a national or international corporation—can much more

readily be relocated elsewhere, as New York discovered after its high taxes causedmany of its big corporations to move their headquarters out of the city. With enough time, even many industries with huge fixed installations canchange their regional distribution—not by physically moving existing dams,buildings, or other structures, but by not building any new ones in theunpromising locations where the old ones are, and by placing new and moremodern structures and installations in states and localities with a better trackrecord of treating businesses as economic assets, rather than economic prey.Meanwhile, places that treated businesses as prey—Detroit being a classicexample—are sympathized with as victims of bad luck when the businesses leaveand take their taxes and jobs with them. A hotel cannot move across state lines, but a hotel chain can build their newhotels somewhere else. New steel mills with the latest technology can likewise bebuilt elsewhere, while the old obsolete steel mill is closed down or phased out. Asin the case of bus fares kept too low to sustain the same level and quality ofservice in the long run, here too the passage of time may be so long that fewpeople connect the political policies and practices of the past with the currentdeterioration of the region into “rustbelt” communities with decliningemployment opportunities for its young people and a declining tax base tosupport local services. “Rustbelts” are not simply places where jobs are disappearing. Jobs arealways disappearing, even at the height of prosperity. The difference is that oldjobs are constantly being replaced by new jobs in places where businesses areallowed to flourish. But in rustbelt communities or regions that have madebusinesses unprofitable with high taxes, red tape and onerous requirements byeither governments or labor unions that impair efficiency, there may not be nearlyas many new jobs as would be required to replace the old jobs that disappear withthe passage of time and the normal changes in economic circumstances. While politicians or people in the media may focus on the old jobs that havedisappeared, the real story consists of the new jobs that do not come to replace

them, but go elsewhere instead of to rustbelt communities that have made themselves hostile environments for economic activity.Time and Foresight Even though many government officials may not look ahead beyond the next election, individual citizens who are subjected to the laws and policies that officials impose nevertheless have foresight that causes many of these laws and policies to have very different consequences from those that were intended. For example, when money was appropriated by the U.S. government to help children with learning disabilities and psychological problems, the implicit assumption was that there was a more or less given number of such children. But the availability of the money created incentives for more children to be classified into these categories. Organizations running programs for such children had incentives to diagnose problem children as having the particular problem for which government money was available. Some low-income mothers on welfare have even told their children to do badly on tests and act up in school, so as to add more money to their meager household incomes. New laws and new government policies often have unanticipated consequences when those subject to these laws and policies react to the changed incentives. For example, getting relief from debts through bankruptcy became more difficult for Americans under a new law passed in 2005. Prior to this law, the number of bankruptcy filings in the United States averaged about 30,000 a week but, just before the new law went into effect, the number of bankruptcy filings spiked at more than 479,000 per week—and immediately afterwards fell below 4,000 a week.{524} Clearly, some people anticipated the change in the bankruptcy law and rushed to file before the new law took effect. Where Third World governments have contemplated confiscation of land for redistribution to poor farmers, many years can elapse between the political campaign for redistribution of land and the time when the land is actually

transferred. During those years, the foresight of existing landowners is likely tolead them to neglect to maintain the property as well as they did when theyexpected to reap the long-term benefits of investing time and money in weeding,draining, fencing and otherwise caring for the land. By the time the land actuallyreaches the poor, it may be much poorer land. As one development economist putit, land reform can be “a bad joke played on those who can least afford tolaugh.”{525} The political popularity of threatening to confiscate the property of richforeigners—whether land, factories, railroads or whatever—has led many ThirdWorld leaders to make such threats, even when they were too fearful of theeconomic consequences to actually carry out these threats. Such was the case inSri Lanka in the middle of the twentieth century: Despite the ideological consensus that the foreign estates should be nationalized, the decision to do so was regularly postponed. But it remained a potent political threat, and not only kept the value of the shares of the tea companies on the London exchange low in relation to their dividends, but also tended to scare away foreign capital and enterprise.{526} Even very general threats or irresponsible statements can affect investment,as in Malaysia, during an economic crisis: Malaysia’s prime minister, Mahathir Mohamad, tried to blame Jews and whites who “still have the desire to rule the world,” but each time he denounced some foreign scapegoat, his currency and stock market fell another 5 percent. He grew quieter.{527} In short, people have foresight, whether they are landowners, welfaremothers, investors, taxpayers or whatever. A government which proceeds as if theplanned effect of its policies is the only effect often finds itself surprised orshocked because those subject to its policies react in ways that benefit or protectthemselves, often with the side effect of causing the policies to produce verydifferent results from what was planned.

Foresight takes many forms in many different kinds of economies. Duringperiods of inflation, when people spend money faster, they also tend to hoardconsumer goods and other physical assets, accentuating the imbalance betweenthe reduced amount of real goods available in the market and the increasedamount of money available to purchase these goods. In other words, theyanticipate future difficulties in finding goods that they will need or in havingassets set aside for a rainy day, when money is losing its value too rapidly to fulfillthat role as well. During the runaway inflation in the Soviet Union in 1991, bothconsumers and businesses hoarded: Hoarding reached unprecedented proportions, as Russians stashed huge supplies of macaroni, flour, preserved vegetables, and potatoes on their balconies and filled their freezers with meat and other perishable goods.{528} Business enterprises likewise sought to deal in real goods, rather thanmoney: By 1991, enterprises preferred to pay each other in goods rather than rubles. (Indeed, the cleverest factory managers struck domestic and international barter deals that enabled them to pay their employees, not with rubles, but with food, clothing, consumer goods, even Cuban rum.){529} Both social and economic policies are often discussed in terms of the goalsthey proclaim, rather than the incentives they create. For many, this may be duesimply to shortsightedness. For professional politicians, however, the fact thattheir time horizon is often bounded by the next election means that any goal thatis widely accepted can gain them votes, while the long-run consequences cometoo late to be politically relevant at election time, and the lapse of time can makethe connection between cause and effect too difficult to prove withoutcomplicated analysis that most voters cannot or will not engage in. In the private marketplace, however, experts can be paid to engage in suchanalysis and exercise such foresight. Thus the bond-rating services Moody’s and

Standard & Poor’s downgraded California’s state bonds in 2001, {530} even thoughthere had been no default and the state budget still had a surplus in its treasury.What Moody’s and Standard & Poor’s realized was that the huge costs of dealingwith California’s electricity crisis were likely to strain the state’s finances for yearsto come, raising the possibility of a default on state bonds or a delay in payment,which amounts to a partial default. A year after these agencies had downgradedthe state’s bonds, it became public knowledge that the state’s large budgetsurplus had suddenly turned into an even larger budget deficit—and manypeople were shocked by the news.

PART V: THE NATIONAL ECONOMY

Chapter 16

NATIONAL OUTPUT Commonsense observation as well as statistics are necessary for assessing the success of an economy. Theodore Dalrymple{531} Just as there are basic economic principles which apply in particular marketsfor particular goods and services, so there are principles which apply to theeconomy as a whole. For example, just as there is a demand for particular goodsand services, so there is an aggregate demand for the total output of the wholenation. Moreover, aggregate demand can fluctuate, just as demand for individualproducts can fluctuate. In the four years following the great stock market crash of1929, the money supply in the United States declined by a staggering one-third. {532} This meant that it was now impossible to continue to sell as many goods andhire as many people at the old price levels, including the old wage levels. If prices and wage rates had also declined immediately by one-third, then ofcourse the reduced money supply could still have bought as much as before, andthe same real output and employment could have continued. There would havebeen the same amount of real things produced, just with smaller numbers ontheir price tags, so that paychecks with smaller numbers on them could havebought just as much as before. In reality, however, a complex national economy

can never adjust that fast or that perfectly, so there was a massive decline in totalsales, with corresponding declines in production and employment. The nation’sreal output in 1933 was one-fourth lower than it was in 1929.{533} Stock prices plummeted to a fraction of what they had been and Americancorporations 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 thegreatest economic catastrophe in the history of the United States. Moreover, thedepression 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’ electoraltriumph 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 werestill evident in the twenty-first century. THE FALLACY OF COMPOSITION While some of the same principles which apply when discussing markets forparticular goods, industries, or occupations may also apply when discussing thenational 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 avoidwhat philosophers call “the fallacy of composition”—the mistaken assumptionthat what applies to a part applies automatically to the whole. For example, the1990s were dominated by news stories about massive reductions in employmentin particular American firms and industries, with tens of thousands of workersbeing laid off by some large companies and hundreds of thousands in someindustries. Yet the rate of unemployment in the U.S. economy as a whole was thelowest in years during the 1990s, while the number of jobs nationwide rose torecord 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 allindividual investments to get the total investments of the country. Whenindividuals buy government bonds, for example, that is an investment for thoseindividuals. But, for the country as a whole, there are no more real investments—no more factories, office buildings, hydroelectric dams, etc.—than if those bondshad never been purchased. What the individuals have purchased is a right to sumsof money to be collected from future taxpayers. These individuals’ additionalassets are the taxpayers’ additional liabilities, which cancel out for the country as awhole. 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 everybodystands up, everybody will not see better. In a burning building, any givenindividual can get out faster by running than by walking. But, if everybody runs,the stampede is likely to create bottlenecks at doors, preventing escapes bypeople struggling against one another to get out, causing some of those peopleto lose their lives needlessly in the fire. That is why there are fire drills, so thatpeople will get in the habit of leaving during an emergency in an orderly way, sothat more lives can be saved. What is at the heart of the fallacy of composition is that it ignoresinteractions among individuals, which can prevent what is true for one of themfrom being true for them all. Among the common economic examples of the fallacy of composition areattempts to “save jobs” in some industry threatened with higher unemploymentfor one reason or another. Any given firm or industry can always be rescued by asufficiently large government intervention, whether in the form of subsidies,purchases of the firm’s or industry’s products by government agencies, or by othersuch means. The interaction that is ignored by those advocating such policies isthat everything the government spends is taken from somebody else. The 10,000jobs 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 neededto keep those other people employed. The fallacy is not in believing that jobs canbe saved in given industries or given sectors of the economy. The fallacy is inbelieving 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 ishow much its total output adds up to. We also need to understand the importantrole of money in the national economy, which was so painfully demonstrated inthe Great Depression of the 1930s. The government is almost always anothermajor factor in the national economy, even though it may or may not be inparticular industries. As in many other areas, the facts are relativelystraightforward and not difficult to understand. What gets complicated are themisconceptions that have to be unravelled. One of the oldest confusions about national economies is reflected in fearsthat the growing abundance of output threatens to reach the point where itexceeds what the economy is capable of absorbing. If this were true, then massesof unsold goods would lead to permanent cutbacks in production, leading in turnto massive and enduring unemployment. Such an idea has appeared from time totime over more than two centuries, though usually not among economists.However, a Harvard economist of the mid-twentieth century named SeymourHarris seemed to express such views when he said: “Our private economy is facedwith the tough problem of selling what it can produce.”{536} A popular best-sellingauthor of the 1950s and 1960s named Vance Packard expressed similar worriesabout “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 exceededthe purchasing power of their pocketbooks.”{538} A widely used history textbooklikewise 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, whenothers expressed similar views. Why has this not created the problem that somany 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 ismeasured by what that money can buy, how much real goods and services. Thenational output likewise consists of real goods and services. The total real incomeof everyone in the national economy and the total national output are one andthe 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 fromdifferent angles—that is, from the standpoint of income and from the standpointof output. The fear of a permanent barrier to economic growth, based on outputexceeding real income, is as inherently groundless today as it was in past centurieswhen output was a small fraction of what it is today. What has lent an appearance of plausibility to the idea that total output canexceed total real income is the fact that both output and income fluctuate overtime, sometimes disastrously, as in the Great Depression of the 1930s. At anygiven time, for any of a number of reasons, either consumers or businesses—orboth—may hesitate to spend their income. Since everyone’s income depends onsomeone else’s spending, such hesitations can reduce aggregate money incomeand with it aggregate money demand. When various government policiesgenerate 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 makethings turn out badly because aggregate demand falls below aggregate incomeand aggregate output. An economy cannot continue producing at full capacity ifpeople are no longer spending and investing at full capacity, so cutbacks inproduction and employment may follow until things sort themselves out. Howsuch 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 whichdifferent schools of economists may disagree. However, what economists ingeneral agree on is that this situation is very different from the situation feared bythose who foresaw a national economy simply glutted by its own growingabundance because people lack the income to buy it all. What people may lack isthe desire to spend or invest all their income. Simply saving part of their income will not necessarily reduce aggregatedemand because the money that is put into banks or other financial institutions isin turn lent or invested elsewhere. That money is then spent by different peoplefor different things but it is spent nonetheless, whether to buy homes, buildfactories, or otherwise. For aggregate demand to decline, either consumers orinvestors, or both, have to hesitate to part with their money, for one reason oranother. That is when current national output cannot all be sold and producerscut back their production to a level that can be sold at prices that coverproduction costs. When this happens throughout the economy, national outputdeclines and unemployment increases, since fewer workers are hired to produce asmaller output. During the Great Depression of the 1930s, some people saved their money athome in a jar or under a mattress, since thousands of bank failures had led themto distrust banks. This reduced aggregate demand, since this money that wassaved was not invested. Some indication of the magnitude and duration of the Great Depression canbe 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 ofmoney during this era, the 1929 level of real output was not reached again until1936.{540} For an economy to take seven years to get back to its previous level ofoutput is extraordinary—one of the many extraordinary things about the GreatDepression of the 1930s. MEASURING NATIONAL OUTPUT The distinction between income and wealth that was made when discussingindividuals in Chapter 10 applies also when discussing the income and wealth ofthe nation as a whole. A country’s total wealth includes everything it hasaccumulated from the past. Its income or national output, however, is what isproduced during the current year. Accumulated wealth and current output areboth important, in different ways, for indicating how much is available fordifferent purposes, such as maintaining or improving the people’s standard ofliving or for carrying out the functions of government, business, or otherinstitutions. National output during a year can be measured in a number of ways. Themost common measure today is the Gross Domestic Product (GDP), which is thesum total of everything produced within a nation’s borders. An older and relatedmeasure, the Gross National Product (GNP) is the sum total of all the goods andservices produced by the country’s people, wherever they or their resources maybe located. These two measures of national output are sufficiently similar thatpeople who are not economists need not bother about the differences. For theUnited States, the difference between GDP and GNP has been less than onepercent. The real distinction that must be made is between both these measures ofnational 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 countrycan live beyond its current production by using up part of its accumulated stock ofwealth from the past. During World War II, for example, American production ofautomobiles stopped, so that factories which normally produced cars couldinstead produce tanks, planes and other military equipment. This meant thatexisting cars simply deteriorated with age, without being replaced. So did mostrefrigerators, 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 ofcars, refrigerators, housing, and other parts of the nation’s accumulated stock ofwealth which had been allowed to wear down or wear out while production wasbeing devoted to urgent wartime purposes. The durable equipment of consumersdeclined in real value between 1944 and 1945, the last year of the war—and thenmore than doubled in real value over the next five years, as the nation’s stock ofdurable assets that had been depleted during the war was replenished.{541} Thiswas an unprecedented rate of growth. Businesses as well had an acceleratedgrowth of durable equipment after the war. Just as national income does not refer to money or other paper assets, sonational wealth does not consist of these pieces of paper either, but of the realgoods and services that money can buy. Otherwise, any country could get richimmediately just by printing more money. Sometimes national output or nationalwealth is added up by using the money prices of the moment, but most seriouslong-run studies measure output and wealth in real terms, taking into accountprice changes over time. This is necessarily an inexact process because the pricesof different things change differently over time. In the century between 1900 and