Sowell Basic Economics A Citizen's Guide to the Economy
.pdfbarrel of oil fell from $15 in 1977 to $5 by 1998. It is hardly surprising that there were larger known oil reserves after the cost of knowing fell.
Although the reserves of natural resources in a nation are often discussed in terms of physical quantities, economic concepts of cost, prices, and present values must be considered if practical conclusions are to be reached. In addition to needless alarms about natural resources running out, there have also been, conversely, unjustifiably optimistic statements that some poor country has so many billions of dollars' worth of "natural wealth" in the form of iron ore or bauxite deposits or some other natural resource. Such statements mean very little without considering how much it would cost to extract and process those resources. A country with $10 billion worth of some natural resource might as well not have it if the costs of exploration, extraction and processing add up to $11 billion. Only if the demand for that resource rises enough in the future to raise its price above the costs of using it, or if future technological improvements lower the costs of producing it, would this resource become economically relevant.
Statistics on the physical totals of a natural resource may sometimes understate how much wealth that represents, if the costs of extraction and processing are especially low. It has been estimated that, in some parts of Russia, petroleum can be extracted at a cost of less than two dollars a barrel-less than one-tenth its selling price in the world market. In purely physical terms, Russia has larger petroleum reserves than any country outside the Middle East. But it is even better off in economic terms.
Chapter 13
Risks and Insurance
Risks inherent in economic activities can be dealt with in a wide variety of ways. In addition to the commodity speculation and inventory management discussed in the previous chapter, other ways of dealing with risk include stocks, bonds, and insurance. There are also other economic activities analogous to stocks, bonds, and insurance which deal with risks in ways that are legally different, though similar economically. Conversely, there are sources of income which seem similar to ordinary wages, salaries and profits but which are in fact quite different. These include capital gains. There are also systems that call themselves "social insurance" which are not insurance at all. Here, as in so many other places, we cannot go by words but must examine the underlying reality.
Whenever a home, a business, or any other asset increases in value over time, that increase is called a "capital gain." While it is another form of income, it differs from wages and salaries in not being paid right after it is earned, but usually only after an interval of some years. A thirty-year bond, for example, can be cashed in only after thirty years.
If you never sell your home, then whatever increase in value it has will be called an "unrealized capital gain." The same is true for someone who opens a grocery store that grows more valuable as its location becomes known throughout the neighborhood, and as it develops a set of customers who get into the habit of shopping at that particular store. Perhaps after the owner dies, his widow or children may decide to sell the store-and only then will the capital gain be realized.
Sometimes a capital gain comes from a purely financial transaction, where you simply pay someone a certain amount of money today in order to get back a somewhat larger amount of money later on. This happens when you put money into a savings account that pays interest, or when a pawnbroker lends money, or when you buy a $10,000 U. S. Treasury bond for somewhat less than $10,000.
However it is done, this is a trade-off of money today for money in the future. The fact that interest is paid implies that money today is worth more than the same amount of money in the future. How much more depends on many things, and varies from time to time, as well as from country to country at the same time.
BONDS
In the heyday of 19th-century British industrialization, railroad companies could raise the huge sums of money required to build miles of tracks and buy trains, by selling bonds that paid about 3 percent per year. This was possible only because the public had great confidence in both the railroads and the stability of the money. If inflation had been 4 percent a year, those who bought the bonds would have lost real value instead of gaining it. But the value of the British pound sterling was very stable and reliable during that era.
Since those times, inflation has become more common, so the interest rate would now have to cover whatever level of inflation was expected and still leave a prospect of a real gain in terms of an increase in purchasing power.
The risk of inflation varies from country to country and from one era to another so the rate of return on investments must include an allowance for the risk of inflation, which also varies. At the beginning of the twenty-first century, Mexico's government bonds paid a quarter of a point higher interest than those of the United States, while those of Brazil paid half a point higher than those of Mexico. Brazil's interest rate then shot up another percentage point after the emergence of a left-wing candidate for president of the country. Varying risks are reflected in varying risk premiums added to interest rates. As of April 2003, short-term interest rates ranged from less than 2 percent in Hong Kong to 19 percent in Russia and 39 percent in Turkey.
Leaving inflation aside, however, how much would a $10,000 bond that : matures a year from now be worth to you today? That is, how much would you pay today for a bond that can be cashed in for $10,000 next year? Clearly it would not be worth $10,000, because future money is not as valuable as the same amount of present money. Even if you felt certain that you would still be alive a year from now, and even if there were no inflation expected, you would still prefer to have the same amount of money right now rather than later. If nothing else, money that you have today can be put in a bank and earn a year's interest on it. For the same reason, if you had a choice between buying a bond that matures a year from now and another bond of the same face value that matures ten years from now, you would not be willing to bid as much for the one that matures a decade later. What this says is that the same nominal amount of money has different values, depending on how long you must wait to get a return on it.
At a sufficiently high interest rate, you might be willing to wait a long time to get your money back. People buy 30-year bonds regularly, though usually at a higher rate of return than what is paid on financial securities that mature in a year or a decade. On the other hand, at a sufficiently low interest rate, you would not be willing to wait any time at all to get your money back.
Somewhere in between is an interest rate at which you would be indifferent between lending money or keeping it. At that interest rate, the present value of a given amount of future money is equal to some smaller amount of present money. For example if you are indifferent at 4 percent, then a hundred dollars today is worth $104 a year from now to you. Any business or government agency that wants to borrow $100 from you today with a promise to pay you back a year from now will have to make that repayment at least $104. If everyone else has the same preferences that you do, then the interest rate in the economy as a whole will be 4 percent.
What if everyone does not have the same preferences that you do? Suppose that others will lend only when they get back 5 percent more at the end of the year? In that case, the interest rate in the economy as a whole will be 5 percent, simply because businesses and government cannot borrow the money they want for any less and they do not have to offer any more. Faced with a national interest rate of 5 percent, you would have no reason to accept less, even though you would take 4 percent if you had to.
In this situation, let us return to the question of how much you would be willing to bid for a $10,000 bond that matures a year from now. With an interest rate of 5 percent being available in the economy as a whole, it would not pay you to bid more than $9,523.81 for a $10,000 bond that matures a year from now. By investing that same amount of money somewhere else too 0 day at 5 percent, you could get back $10,000 in a year. Therefore, there 1S n '[the reason for you to bid more than $9,523.81 for the $10,000 bond. What 1 5 interest rate in the economy as a
whole had been 12 percent, rather than percent? Then it would not pay you to bid more than $8,928.57 for a $10,000 bond that matures a year from now. In short, what people will bid for bonds depends on how much they could get for the same money by putting it somewhere else. That is why bond prices go down when the interest rate goes up, and vice-versa.
What this also says is that, when the interest rate is 5 percent, $9,523.81 in the year 2000 is the same as $10,000 in the year 2001. This raises questions about the taxation of capital gains. If someone buys a bond for the former price and sells it a year later for the latter price, the government will of course want to tax the $476.19 difference. But is that really the same as an increase in value, if the two sums of money are just equivalent to one another? What if there has been a one percent inflation, so that the $10,000 received back would not have been enough to compensate for waiting, if the investor had expected inflation to reduce the real value of the bond?
What if there had been a 5 percent inflation, so that the amount received back was worth no more than the amount originally lent, with no reward at all for waiting? Clearly, the investor would be worse off than if he or she had never bought the bond. How then can this "capital gain" really be said to be a gain?
These are just some of the considerations that make the taxation of capital gains more complicated than the taxation of such other forms of income as wages and salaries. Some governments in some countries do not tax capital gains at all, while the rate at which such gains are taxed in the United States remains a matter of political controversy.
VARIABLE RETURNS VERSUS FIXED RETURNS
There are many ways of confronting the fact that the real value of a given sum of money varies with when it is received and with the varying likelihood that it will be received at all. Stocks and bonds are just one way of dealing with differing risks. But people who have no interest in buying these financial securities must also confront the same principles in other ways, when choosing a career for themselves or when considering public policy issues for the Country as a whole.
Stocks and Bonds
Bonds differ from stocks because bonds are legal commitments to pay fixed amounts of money on a fixed date. Stocks are simply shares of the business that issues them, and there is no guarantee that the business will make a profit in the first place, much less payout dividends instead of re-investing these profits in the business. Bond-holders have a legal right to be paid what they were promised, whether the business is making money or losing money. In that respect, they are like the business' employees, to whom fixed commitments have been made as to how much they would be paid per hour or per week or month. They are legally entitled to those amounts, regardless of whether the business is profitable or unprofitable. The owners of a business-whether that is a single individual or millions of stockholders-are not legally entitled to
anything, except whatever happens to be left over after a business has paid its employees, bond-holders and other creditors.
Considering the fact that most new businesses fail within a few years, what is left over can just as easily be negative as positive. In other words, people who set up businesses may not only fail to make a profit but may even lose part or all of what they originally invested. In short, stocks and bonds have different amounts of risk. Moreover, the mixture of stocks and bonds sold by different kinds of businesses may reflect the inherent risks of those businesses themselves.
Imagine that someone is raising money to go into a business where (1) the chances are 50-50 that he will go bankrupt and (2) if the business does survive financially, the initial investment will increase ten-fold. Perhaps he is drilling for oil or speculating in foreign currencies. What if he wants you to contribute $5,000 to this venture? If you can afford the risk, would you be better off buying $5,000 worth of stock in this enterprise or $5,000 worth of this company's bonds?
If you buy bonds, your chances are only 50-50 of getting all your money back. And if this enterprise prospers, you are only entitled to whatever rate of return was specified in the bond at the outset, no matter how many millions of dollars the entrepreneur makes with your money. Buying bonds in such a venture does not seem like a good deal. Buying stocks, on the other hand, might make sense. If the business goes bankrupt, your stock could be worthless, while a bond would have some residual value, based on whatever assets might remain to be sold, even if that only pays the bondholders and other creditors pennies on the dollar. On the other hand, if the business succeeds and its assets increase ten-fold, then the value of your stock likewise increases ten-fold.
As a rule of thumb, it has been estimated that a venture capitalist needs at least a 50 percent rate of return on successful investments, in order to cover the losses on the many unsuccessful investments and come out ahead over all. In real life, rates of return on venture capital can vary greatly from year to year. For the 12 months ending September 30, 2001, venture capital funds lost 32.4 percent. That is, not only did these venture capitalists as a whole not make any net profit, they lost nearly one-third of the money they had invested. But, just a couple of years earlier, venture capitalists averaged a rate of return of 163 percent in 1999.
The question of whether this kind of activity is worthwhile from the . standpoint of the venture capitalist can be left to the venture capitalist to worry about. From the standpoint of the economy as a whole, the question is whether this kind of financial activity represents an efficient allocation of scarce resources which have alternative uses. Although individual venture capitalists can go bankrupt, just like the companies they invest in, the venture capital industry as a whole usually does not lose money-that is, it does not waste the available resources of the economy. From the time when data began to be kept on venture capital in 1970, there was not a single year over the next 30 years in which venture capitalists as a whole lost money. However, the fact that they lost money in the 31st year means that nothing is a sure thing. It is in fact remarkable that something which looks as risky as venture capital usually works out from the standpoint of the economy as a whole, even if not from the standpoint of every venture capitalist.
Now look at stocks and bonds from the standpoint of the entrepreneur who is trying to raise money for a risky undertaking. Knowing that bonds would be unattractive to investors and that a bank would likewise be reluctant to lend to him because of the high risks, he would almost certainly try to raise money by selling stocks instead. At the other end of the risk spectrum, consider a public utility that supplies something the public always needs, such as water or electricity. There is usually very little risk involved in putting money into such an enterprise, so
the utility can issue and sell bonds, without having to pay the higher amounts that investors would earn on stocks. In short, risks vary among businesses and their financial arrangements vary accordingly. At one extreme, a commodity speculator can go from profits to losses and back again, not only from year to year but even from hour to (1) There are exceptions to virtually every rule. People who bought bonds in California's electric utility companies, as a safe investment for their retirement years, saw most of the value of those investments vanish into thin air during that state's electricity crisis of 2001. The state forced these utilities to sell electricity to their customers for less than they were paying their suppliers. As these utilities went billions of dollars into debt, their bonds were downgraded to level of junk bonds. hour on a given day. That is why there are television pictures of frantic shouting and waving in commodity exchanges, where prices are changing so rapidly that the difference between making a deal right now and making it five minutes from now can be vast sums of money.
A more common pattern among those businesses that succeed is one of low income or no income at the beginning, followed by higher earnings after the enterprise becomes established. For example, a dentist first starting out in his profession after graduating from dental school and buying the costly equipment needed, may have little or no net income the first year, before becoming known widely enough in the community to attract a large clientele.
During that interim, the dentist's secretary may be making more money than the dentist. Later on, of course, the situation will reverse and some observers may then think if unfair that the dentist makes several times the income of the secretary.
Even when variable sums of money add up to the same total as fixed sums of money, they are unlikely to be equally attractive. Would you be equally as likely to enter two occupations with the same average income-say, $50,000 a year-over the next decade if one occupation paid $50,000 every year while the income in the other occupation might vary from $10,000 one year to $90,000 the next year and back again, in an unpredictable pattern? Chances are you would require a somewhat higher average income in the occupation with variable pay, to make it equally attractive with the occupation with a reliably fixed income. Accordingly, stocks usually yield a higher average rate of return than bonds, since stocks have a variable rate of return (including, sometimes, no return at all), while bonds have a guaranteed fixed rate of return. It is not some moral principle that makes this happen. It happens because people will not take the risk of buying stocks unless they can expect a higher average rate of return than they get from bonds.
The degree of risk varies not only with the kind of investment but also with the period of time. For a period of one year, bonds are likely to be much safer than stocks. But for a period of 20 or 30 years, the risk of inflation threatens the value of bonds or other assets with fixed-dollar amounts, such as bank accounts, while stock prices tend to rise with inflation like real estate, factories, or other real assets. Being shares of real assets, stocks share in the rising price of real assets during inflation. Moreover, even in the absence of inflation, stock prices can generally be relied on to rise over a period of decades, while bond prices and the prices of other fixed-dollar assets do not.
Therefore the relative safety of the two kinds of assets can be quite different in the long run than in the short run.
Someone planning for retirement many years in the future may find a suitable mixture of stocks a much safer investment than someone who will need the money in a year or two. "Like money in the bank" is a popular phrase used to indicate something that is a very safe bet, but money in the bank is not particularly safe over a period of decades, when inflation can steal much of its value. The same is true of bonds. Eventually, after reaching an age when the
remaining life expectancy is no longer measured in decades, it may be prudent to begin transferring money out of stocks and into bonds, bank accounts, and other assets with greater short-run safety.
Risk and Time
To take an extreme example of how risk can vary over time, while a dollar invested in bonds in 1801 would be worth nearly a thousand dollars by 1998, a dollar invested in stocks that same year would be worth more than half a million dollars. All this is in real terms, taking inflation into account. Meanwhile, a dollar invested in gold in 1801 would in 1998 be worth just 78 cents.
The phrase "as good as gold" can be as misleading as the phrase "money in the bank," when talking about the long run. While there have been many short-run periods when bonds and gold held their values as stock prices plummeted, the relative safety of these different kinds of investments varies greatly with how long a time period you have in mind. Moreover, the pattern is not the same in all eras.
The real rate of return on American stocks was just 3.6 percent during the Depression decade from 1931 to 1940, while bonds paid 6.4 percent. However, bonds had a negative rate of return in real terms during the succeeding decades of the 1940s, 1950, 1960s and 1970s, while stocks had positive rates of return during that period. In other words, money invested in bonds during those inflationary decades would not buy as much when these bonds Were cashed in as when the bonds were bought, even though larger sums of money were received in the end. With the restoration of price stability in the last two decades of the twentieth century, both stocks and bonds had positive rates of real returns.
Risk is always specific to the time at which a decision is made. "Hindsight is twenty-twenty," but risk always involves looking forward, not backward.
During the early, financially shaky years of McDonald's, the company was so desperate for cash at one point that its founder, Ray Kroc, offered to sell half Interest in McDonald's for $25,000-and no one accepted his offer. If anyone had, that person would have become a billionaire over the years. But, at the time, it was neither foolish for Ray Kroc to make that offer nor for others to turn it down.
The relative safety and profitability of various kinds of investments depends on your own knowledge. An experienced expert in financial transactions may grow rich speculating in gold, while people of more modest knowledge are losing big. However, with gold you are unlikely to be completely wiped out, since gold always has a value for jewelry and industrial uses, while any given stock can end up not worth the paper it is written on.
Nor is it only novices who lose money in the stock market. Harvard's $13 billion endowment fell by 10 percent-more than a billion dollars-in less than three months. In the past, colleges and universities kept their endowments in safe investments like government bonds but, during the stock market boom of the 1990s, many went for higher rates of return in the private financial markets. As The Wall Street Journal put it, these academic institutions "are re-learning the lesson that high returns often are achieved by taking high risks." Even top executives with inside knowledge can go wrong. The former Chief Executive Officer of Yahoo! Inc. sold $25
million worth of that company's stock that he owned in 200l-just before the stock's price shot up 65 percent. That same year, the 400 richest Americans lost a total of $80 billion.
Risk and Diversification
The various degrees and varieties of risk can be dealt with by having a variety of investments-a "portfolio," as they say-so that when one kind of investment is not doing well, other kinds may be flourishing, thereby reducing the over-all risk to your total assets. For example, as already noted, bonds may not be doing well during a period when stocks are very profitable, or vice versa. A portfolio that includes a combination of stocks and bonds may be much less risky than investing exclusively in either. Even adding an individually risky investment like gold, whose price is very volatile, to a portfolio can reduce the risk of the portfolio as a whole, since gold prices tend to move in the opposite direction from stock prices.
A portfolio consisting mostly-or even solely-of stocks can have its risks reduced by having a mixture of stocks from different companies. These may be a group of stocks selected by a professional investor who charges others for selecting and managing their money in what is called a "mutual fund.
Where the selection of stocks bought by the mutual fund is simply a mixture based on whatever stocks make up the Dow Jones Industrial average or the Standard & Poor's Index, then there is less management required and less may be charged for the service.
Theoretically, those mutual funds where the managers actively follow the various markets and then pick and choose which stocks to buy and sell should average a higher rate of return than those mutual funds which simply buy whatever stocks happen to make up the Dow Jones or Standard & Poor's index. Some actively managed mutual funds do in fact do better than index mutual funds, but in many years the index funds have had higher rates of return than most of the actively managed funds, much to the embarrassment of the latter.
On the other hand, the index funds offer little chance of a big killing, such as a highly successful actively managed fund might. A reporter for the Wall Street Journal who recommended index funds for people who don't have the time or the confidence to buy their own stocks individually said: "True, you might not laugh all the way to the bank. But you will probably smile smugly." However, index mutual funds lost 9 percent of their value in the year 2000, so there is no complete freedom from risk anywhere. For mutual funds as a whole-both managed funds and index funds-a $10,000 investment in early 1998 would by early 2003 be worth less than $9,000. Out of a thousand established mutual funds, just one made money every year of the decade ending in 2003.
While mutual funds made their first appearance in the last quarter of the twentieth century, the economic principles of risk-spreading have long been understood by those investing their own money. In centuries past, ship owners often found it more prudent to own 10 percent of ten different ships, rather than own one ship outright. The dangers of a ship sinking were much greater in the days of wooden ships and sails than in the modern era of metal, mechanically powered ships. Owning 10 percent shares in ten different ships increased the danger of a loss through sinking but greatly reduced how catastrophic that loss would be.
Investing in Human Capital
Investing in human capital is in some ways similar to investing in other kinds of capital and in some ways different. People who accept jobs with no pay, or with pay much less than they could have gotten elsewhere, are in effect investing their working time, rather than money, in hopes of a larger future return than they would get by accepting a job that pays a higher salary initially. But, where someone invests in another person's human capital, the return on this investment is not as readily recovered by the investor. Typically, those who use other people's money to pay for their education, for example, either receive that money as a gift-from parents or philanthropic individuals or organizations, for example-or else borrow the money.
While students can, in effect, issue bonds, they seldom issue stocks. That is, many students go into debt to pay for their education but rarely sell percentage shares of their future earnings. In the few cases where students have done that, they have often felt resentful in later years at having to continue contributing a share of their income after their payments have already covered all of the initial investment made in them. But dividends from corporations that issue stock likewise continue to be paid in disregard of whether the initial investment has been repaid. That is the difference between stocks and bonds.
It is misleading to look at this situation only after an investment in human capital has paid off. Stocks are issued precisely because of risks that the investment will not payoff. Given that a substantial number of college students will never graduate, and that even some of those who do may have meager incomes, the pooling of risks enables more private financing to be made available to college students in general. Ideally, if prospective students could and did issue both stocks and bonds in themselves, it would be unnecessary for parents or taxpayers to subsidize their education, and even poverty-stricken students could go to the most expensive colleges without financial aid. However, legal problems, institutional inertia, and social attitudes have kept such arrangements from becoming widespread in colleges and universities.
In some endeavors, however, it is feasible to have human beings in effect issue both stocks and bonds in themselves. Boxing managers have often owned percentage shares of their fighters' earnings. Thus many poor youngsters have received years of instruction in boxing that they would have been unable to pay for. Nor would simply going into debt to pay for this instruction be feasible because the risks are too high for lenders to lend in exchange for a fixed repayment. Some boxers never make it to the point where their earnings from fighting would enable them to repay the costs of their instruction and management. Nor are such boxers likely to have alternative occupations from which they could repay large loans to cover the costs of their failed boxing careers. Consider, for example, the fact that only one heavyweight champion ever had a college degree (Gene Tunney). More heavyweight champions than that have been on welfare or served time in prison.
Given the poor backgrounds from which most boxers have come and the high risk that they will never make any substantial amount of money, financing their early training in effect by stocks makes more sense than financing it by bonds. A fight manager can collect a dozen young men from tough neighborhoods as boxing prospects, knowing that most will never repay his investment of time and money, but calculating that a couple probably will, if he has made wise choices. Since there is no way to know in advance which ones these will be, the point is to have enough financial gains from shares in the winning fighters to offset the losses on the fighters who
never make enough money to repay the investment.
For similar reasons, Hollywood agents have acquired percentage shares in the future earnings of young unknown actors and actresses who looked promising, thus making it worthwhile to invest time and money in the development and marketing of their talent. The alternative of having these would-be movie stars pay for this service by borrowing the money would be far less feasible, given the high risk that the majority who fail would never be able to repay the loans and might well disappear after it was clear that they were going nowhere in Hollywood.
At various times and places, it has been common for labor contractors to supply teams of immigrant laborers to work on farms, factories, or construction sites, in exchange for a percentage share of their earnings. In effect, the contractor owns stock in the workers, rather than bonds. Such workers have often been both very poor and unfamiliar with the language and customs of the country, so that their prospects of finding their own jobs individually have been very unpromising. In the nineteenth and early twentieth centuries, vast numbers of contract laborers from Italy went to countries in the Western Hemisphere and contract laborers from China went to countries in Southeast Asia, while contract laborers from India spread around the world to British Empire countries from Malaysia to Fiji to British Guiana.
In short, investment in human capital, as in other capital, has been made in the form of stocks as well as bonds. Although these terms have not been used legally, that is what they have amounted to economically.
These are just some of the ways in which risks can be spread, thereby reducing the total risk. Insurance is another example.
INSURANCE
Like commodity speculators, insurance companies deal with inherent and I inescapable risks. Insurance both transfers and reduces those risks. In exchange for the premium paid by its policy-holder, the insurance company assumes the risk of compensating for losses caused by automobile accidents, houses catching fire, and numerous other misfortunes which befall human beings. There are more than 41,000 insurance carriers in the United States alone. That includes more than 11,000 life insurance companies, whose total assets exceed 3 trillion dollars.
In addition to transferring risks, an insurance company seeks to reduce them. For example, it charges lower prices to safe drivers and refuses to insure some homes until brush and other flammable materials near a house are removed. People working in hazardous occupations are charged higher premiums. In a variety of ways, it segments the population and charges different prices to people with different risks. That way it reduces its own over-all risks and, in the process, sends a signal to people working in dangerous jobs or living in dangerous neighborhoods, conveying to them the costs created by their chosen behavior or location.
The most common kind of insurance-life insurance-compensates for a misfortune that cannot be prevented. Everyone must die but the risk involved is in the time of death. If everyone were known in advance to die at age 70, there would be no point in life insurance, because there would be no risk involved. Each individual's financial affairs could be arranged in advance to take that predictable death into account. Paying premiums to an insurance company would make