Sowell Basic Economics A Citizen's Guide to the Economy

the city, taking the taxes they pay with them, so many years may have elapsed since the political bus fare controversy that few people remember it or see any connection between that controversy and their current problems. Meanwhile, the politician who won a municipal election by assuming the role of champion of the bus riders may now have moved on up to statewide office, or even national office, on the basis of his popularity.

As a declining tax base causes deteriorating city services and neglected infrastructure, the erstwhile hero of the bus riders may even be able to boast that things were never this bad when he was a city official, and blame the current problems on the failings of his successors. In economics, however, future consequences are anticipated in the concept of "present value." If, instead of fares being regulated by a municipal government, these fares were set by a private bus company operating in a free market, any neglect of financial provisions for replacing buses as they wear out would begin immediately to reduce the value of the bus company's stock. In other words, the present value of the bus company would decline as a result of the long-run consequences that were anticipated by investors concerned about the safety and profitability of their own money.

If a private bus company's management decided to keep fares too low to maintain and replace its buses as they wore out, perhaps deciding to pay themselves higher executive salaries instead of setting aside funds for the maintenance of their bus fleet, 99 percent of the public might still be unaware of this or its long-run consequences. But among the other one percent who would be far more likely to be aware would be those in charge of financial institutions that owned stock in the bus company, or were considering buying that stock or lending money to the bus company. For these investors, potential investors, or lenders examining financial records, the company's present value would be seen as reduced, long before the first bus wore out.

As in other situations, a market economy allows accurate knowledge to be effective in influencing decision-making, even if 99 percent of the population do not have that knowledge. In politics, however, the 99 percent who do not understand can create immediate political success for officials and policies that will turn out in the end to be harmful to society as a whole. It would of course be unreasonable to expect the general public to become financial experts or any other kind of experts. What may be more reasonable is to expect enough voters to see the dangers in letting economic decisions be made through political processes.

Time can turn economies of scale from an economic advantage to a political liability. After a business has made a huge investment in a fixed installation-a gigantic automobile factory, a hydroelectric dam, a skyscraper-the fact that this asset cannot be moved makes it a tempting target for high local taxation or for the unionization of employees who can shut it down with a strike and impose huge losses unless their demands are met. Where labor costs are a small 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. By contrast, an office-even the headquarters office of a national or international corporation-can much more readily be moved elsewhere, as New York discovered after its high taxes caused many of its big corporations to move their headquarters out of the city. With enough time, even many industries with huge fixed installations can change their regional distribution-not by physically moving existing dams, buildings, or other structures, but by not building any new ones in the unpromising locations where the old ones are, and by placing new and more modern structures and installations in states and localities with a better track record of treating businesses as economic assets, rather than economic prey.

A hotel cannot move across state lines, but a hotel chain can build their new hotels

somewhere else. New steel mills with the latest technology can likewise be built elsewhere, while the old obsolete steel mill is closed down or phased out. As in the case of bus fares kept too low to sustain the same level and quality of service in the long run, here too the passage of time may be so long that few people connect the political policies and practices of the past with the current deterioration of the region into "rust belt" communities with declining employment opportunities for its young people and a declining tax base to support local services.

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 tax rates are raised 10 percent, it may be assumed that tax revenues will also rise by 10 percent. But in fact more people may move out of the heavily taxed jurisdiction, or buy less of the heavily taxed commodity, so that the revenues received may be disappointingly far below what was estimated. The state of Alaska discovered this when it passed a law greatly increasing its tax rates on cigarettes The tax was to go into effect October 1, 1997. Smokers struck back by buying an astounding 175 million more cigarettes than usual in the three months before the tax deadline. Richard Watts of the Great Alaska Tobacco Company told the local papers that some smokers even bought sixty-carton cases-at $1,200 each-rather than pay the tax. As for Alaska's Department of Revenue, it saw its revenue go up in smoke: collections slowed 60 percent following the infamous increase date.

Conversely, when the federal tax rate on capital gains was lowered from 28 percent to 20 percent in 1997, it was assumed that revenues from the capital gains tax would fall below the $54 billion collected in 1996 and the $209 billion projected to be collected over the next four years, before the tax rate was cut. Instead, tax revenues rose after the capital gains tax rate was Cut: $372 billion were collected in capital gains taxes over the next four years. People adjusted their behavior to a more favorable outlook for investments by increasing their investments, so that the new 20 percent tax rate on the returns from these increased investments amounted to more revenue than that produced by the old 28 percent tax rate. Instead of keeping their money in tax-exempt municipal bonds, for example, investors would now find it more advantageous to invest in producing real goods and services With a higher rate of return, now that lower tax rates enabled them to keep more of their gains. It was much the same story halfway around the world in India:

Lower income taxes brought greater compliance and more revenues for the treasury. Direct taxes in 1995-96 accounted for 29 percent of revenues, compared to 19 percent in 1990-91.

Although it is common in politics and in the media. to refer to government's "raising taxes" or "cutting taxes," this blurs a crucial distinction between tax rates and tax revenues. The government can change tax rates but the reaction of the public to these changes can result in either a higher or a lower amount of tax revenues being collected. Thus references to proposals for a "$500 billion tax cut" or a "$700 billion tax increase" are wholly misleading because all that the government can enact is a change in tax rates, whose actual consequences can be determined only after the fact.

The foresight of people subjected to various government policies can also cause results to differ from intentions when it comes to social policies. 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 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.

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 it is actually done. During those years, the foresight of existing landlords is likely to lead them to neglect to maintain the property as well as they did when they expected to reap the long-terms benefits of investing time and money in weeding, draining, fencing and otherwise caring for the land. By the time the land actually reaches the poor, it may be much poorer land. As one development economist put it, land reform can be "a bad joke on those who can least afford to laugh." The political popularity of threatening to confiscate the property of rich foreigners-whether land, factories, railroads or whatever-has led many Third World leaders to make such threats, even when they were too fearful of the economic consequences to actually carry out these threats. Such was the case in Sri 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.

In short, people have foresight, whether they are landowners, welfare mothers, investors, taxpayers or whatever. A government which proceeds as if the planned effect of its policies is the only effect often finds itself surprised or shocked because those subject to the policies react in ways that benefit or protect themselves, often with the side effect of causing the polices to produce very different results from what was planned.

Foresight takes many forms in many different kinds of economies. During periods of inflation, when people spend money faster, they also tend to hoard consumer goods and other assets, accentuating the imbalance between the reduced amount of real output available in the market and the increased amount of money available to purchase it. In other words, they anticipate future difficulties in finding goods that they will need or in having assets set aside for a rainy day, when money is losing its value too rapidly to fulfill that role as well. During the runaway inflation in the Soviet Union in 1991, both consumers and businesses hoarded:

Hoarding reached unprecedented proportions, as Russians stashed hug supplies of macaroni, flour, preserved vegetables, and potatoes on their balconies and filled their freezers with meat and other perishable goods.

Business enterprises likewise sought to deal in real goods, rather than money: 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.

Both social and economic policies are often discussed in terms of the goals . they proclaim, rather than the incentives they create. For many, this may be due simply to shortsightedness. For

professional politicians, however, the fact that their time horizon is often bounded by the next election means that any goal that is widely accepted can gain them votes, while the long-run consequences come too late to be politically relevant, and the lapse of time can make the connection between cause and effect can be too difficult to prove without complicated analysis that most voters cannot or will not engage in. In the private marketplace, however, experts can be paid to engage in such analysis and exercise such foresight. Thus the bond-rating services Moody's and Standard & Poor's downgraded California's state bonds in 2001, even though there 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 dealing with California's electricity crisis were likely to strain the state's finances for years to 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 downgraded the state's bonds, it became public knowledge that the state's large budget surplus had suddenly turned into an even larger budget deficit-and many people were shocked by the news.

PART V:

THE NATIONAL ECONOMY

Chapter 15

National Output

Just as there are basic economic principles which apply in particular markets for particular goods and services, so there are principles which apply to the economy as a whole. For example, just as there is a demand for particular goods and services, so there is an aggregate demand for the total output of the whole nation. Moreover, aggregate demand can fluctuate, just as demand for individual things can fluctuate. In the three years following the great stock market crash of 1929, the money supply in the United States declined by a staggering one-third. This meant that it was now impossible to continue to sell as many goods and hire 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 of course the reduced money supply could still , have bought as much as before, and the same real output and employment could have continued. There would have been the same amount of real I things produced, just with smaller numbers on their price tags, so that paychecks with smaller numbers on them could have bought 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 total sales, with corresponding declines in production and employment.

Thus began the Great Depression of the 1930s, during which as many as one-fourth of all workers were unemployed and American corporations as a whole operated at a loss for two years in a row. U. S. Steel stock went from 261314 to 211/4 and General Electric fell from 396 1/4 to 70 1/4 in 1932.,General Motors stock, which peaked at 72 3/4 in 1929, hit bottom at 7 5/8.

On the entire decade of the 1930s, unemployment averaged more than 18 percent. It was the greatest economic catastrophe in the history of the United States. The fears, policies and institutions it generated were still evident more than half a century later.

THE FALLACY OF COMPOSITION

While some of the same principles which apply when discussing markets for particular goods, industries, or occupations may also apply when discussing the national economy, it cannot be assumed in advance that this is always the case. When thinking about the national economy, a special challenge will be to avoid what philosophers call "the fallacy of composition"-the mistaken assumption that what applies to a part applies automatically to the whole.

For example, the 1990s were dominated by news stories about massive reductions in

employment in particular American firms and industries, with tens of thousands of workers being laid off by some large companies and hundreds of thousands in some industries. Yet the rate of unemployment in the U.S. economy as a whole was the lowest in years during the 1990s, while the number of jobs nationwide rose to record high levels. What was true of the various sectors of the economy that made news in the media was not true of the economy as a whole.

The fallacy of composition threatens confusion in many aspects of the study of the national economy, because what is true of an individual or even an industry is not necessarily true for the economy. For example, any given individual who doubles the amount of money he or she has will be richer, but a nation cannot be made richer by printing twice as much money. That is because the price level will rise in the economy as a whole if there is twice as much money in circulation and the same amount of goods.

Another example of the fallacy of composition would be adding up all individual investments to get the total investments of the country. When individuals buy government bonds, that is an investment for those individuals.

But, for the country as a whole, there are no more investment goods-office buildings, factories, hydroelectric dams, etc.-than if these bonds had never been purchased. What these individuals have purchased is a right to sums of money to be collected from future taxpayers. These individuals' additional assets are the taxpayers' additional liabilities, which cancel out for the country as a whole.

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

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

Among the common economic examples of the fallacy of composition are attempts to "save jobs" in some industry threatened with higher unemployment for one reason or another. Any given firm or industry can always be rescued by a sufficiently large government intervention, whether in the form of subsidies, purchases of the firm's or industry's products by government agencies, or by other such means. The interaction that is ignored by those advocating such policies is that everything the government spends is taken from somebody else. The 10,000 jobs saved in the widget industry may be at the expense of 15,000 jobs lost elsewhere in the economy by the government's taxing away the resources needed to keep those other people employed.

We need only imagine what would have happened if the government had decided to "save jobs" in the typewriter industry when personal computers first appeared on the scene and began to take away customers from the typewriter manufacturers. If laws had been passed restricting the number of computers that could be sold, this would undoubtedly have saved the jobs of many people who manufactured typewriters or who produced typewriter ribbons, carbon paper, and other accessories. But there would have been fewer jobs created in the computer-manufacturing industry and in the many branches of the software industry. The fallacy is not in believing that jobs can be saved in given industries or given sectors of the economy. The fallacy is in believing that these are net savings of jobs for the economy as a whole.

OUTPUT AND DEMAND

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

One of the oldest confusions about national economies is reflected in fears that the growing abundance of output threatens to reach the point where it exceeds what the economy is capable of absorbing. If this were true, then masses of unsold goods would lead to permanent cutbacks in production, leading in turn to massive and permanent unemployment. Such an idea has appeared from time to time over more than two centuries, though usually not among economists. However, a Harvard economist of the mid-twentieth century named Seymour Harris seemed to express such views when he said:

"Our private economy is facing the tough problem of selling what it can produce." A popular, best-selling author of the 1950s and 1960s named Vance Packard expressed similar worries about "a threatened overabundance of the staples and amenities and frills of life" which have become "a major national problem" for the United States." Yet today's output is several times what it was when Professor Harris and Mr. Packard expressed their worries, and many times what it was in the eighteenth and nineteenth centuries, when others expressed similar worries. Why has this not created the problem that so many have feared for so long, the problem of insufficient income to buy the ever-growing output that has been produced?

First of all, while income is usually measured in money, real income is measured by what that money can buy, how much real goods and services.

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

What has lent an appearance of plausibility to the idea that total output can exceed total income is the fact that both output and income fluctuate over time, sometimes disastrously, as in the Great Depression of the 1930s.

At any given time, for any of a number of reasons, either consumers or businesses-or both-may hesitate to spend their income. Since everyone's income depends on someone else's spending, such hesitations can reduce aggregate income and with it aggregate demand. So can mismanagement of the money supply by government officials. Moreover, when various government policies generate uncertainty and apprehensions, this can lead individuals and businesses to want to hold on to their money until they see how things are going to turn out.

When millions of people do this at the same time, that in itself can make things turn out badly. An economy cannot continue operating at full capacity if people are no longer spending

and investing at full capacity, so cutbacks in production and employment may follow until things sort themselves out.

How such situations come about, how long it will take for things to sort themselves out, and what policies are best to cope with these problems are all things on which different schools of economists may disagree. However, what economists in general agree on is that this situation is very different from the situation feared by those who foresaw a national economy glutted by its own growing abundance because people lack the income to buy it all.

MEASURING NATIONAL OUTPUT

The distinction between income and wealth that was made when discussing individuals in Chapter 9 applies also when discussing the income and wealth of the nation as a whole. A country's total wealth includes everything it has left from the past plus everything currently being produced. National output, however, is what is produced during a given year. Both are important in different ways for indicating how much is available for different purposes, such as maintaining or improving the people's standard of living, or for carrying Out the functions of government, business, government or other institutions.

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

The real distinction that must be made is between both these measures of national output during a given year--a flow of real income-versus the accumulated stock of wealth as of a given time. For example, at any given time, a country can live beyond its current production by using up part of its accumulated stock of wealth from the past. During World War II, for example, American production of automobiles stopped, so that factories which normally produced cars could instead produce tanks, planes and other military equipment. This meant that existing cars simply deteriorated, as did most refrigerators, apartment buildings and other parts of the national stock of wealth. Wartime government posters said:

Use it up, Wear it out, Make it do, Or do without.

After the war was over, there was a tremendous increase in the production of cars, refrigerators, housing, and other parts of the nation's accumulated stock of wealth which had been allowed to wear down or wear out while production was being devoted to urgent wartime purposes. Both the fixed assets of businesses and the durable equipment of consumers grew much faster between 1947 and 1973 than they had during earlier or later decades of the twentieth century, as the nation's stock of durable assets that had been depleted during the war was replenished.

Just as national income does not refer to money or other paper assets, so national wealth does not consist of these pieces of paper either, but of the real goods and services that such things can buy. Otherwise, any country could get rich immediately just by printing more money.

Sometimes national output or national wealth is added up by using the money prices of the moment, but most serious long-run studies measure output and wealth in real terms, taking into account price changes over time. This is necessarily an inexact process because the prices of different things change differently over time. In the century between 1900 and 2000, the real cost of electricity, eggs, bicycles, and clothing all declined in the United States, while the real cost of bread, beer, potatoes, and cigarettes all rose.

The Composition of Output

Prices are not the only things that change over time. The real goods and services which make up the national output also change. The cars of 1950 are not the same as the cars of the year 2000. The older cars did not have air-conditioning, seat belts, anti-lock brakes, or many other features that have been added over the years. So when we try to measure how much the production of automobiles has increased in real terms, a mere count of how many such vehicles there were in both time periods misses a huge qualitative difference in what we are defining as being the same thing cars. This is true of housing as well. The average house at the end of the twentieth century was much larger, had more bathrooms, and was far more " likely to have air conditioning and other amenities than houses that existed in the middle of that century. Merely counting how many houses there were at both times does not tell us how much the production of housing had increased. Just between 1983 and 2000, the median square feet in a new single-family house in the United States increased from 1,585 to 2,076.

While these are problems which can be left for professional economists and statisticians to try to wrestle with, it is important for others to at least be aware of these problems, so as not to be misled by politicians or media pundits who throw statistics around for one purpose or another.

Comparisons over Time

Over a period of generations, the goods and services which constitute national output change so much that statistical comparisons can become practically meaningless, because they are comparing apples and oranges. At the beginning of the twentieth century, the national output did not include any airplanes, television sets, computers or nuclear power plants. At the end of that century, national output did not include many typewriters, slide rules (once essential for engineers, before there were electronic calculators), or a host of equipment and supplies once widely used in connection with horses that formerly provided the basic transportation of the country.

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

'International Comparisons

The same problems which apply when comparing a given country's output versus time can also apply when comparing the output of two very different countries at the same time. If some Caribbean nation's output consists largely of bananas and other tropical crops, while some Scandinavian country's output consists more of industrial products and crops more typical of cold climates, how is it possible to compare totals made up of such differing items? This is not just comparing apples and oranges, it may be comparing cars and sugar.

Statistical comparisons of incomes in Western and non-Western nations are affected by the same age differences that exist within nations. For example, the median ages in Afghanistan, Yemen, and Angola are all below twenty, while the median ages in Germany and Italy is about forty. Such huge age gaps overstate the real significance of some international differences in income. Just as nature provides-free of charge-the heat required to grow pineapples or bananas in tropical countries, while other countries would run up huge heating bills growing these same fruits in greenhouses, so nature provides free for the young many things that can be very costly to provide for older people.

Enormously expensive medications and treatments for dealing with the many physical problems that come with aging are all counted in statistics on a country's output, but fewer such things are necessary in a country with a younger population. Thus statistics on real income per capita overstate the difference in economic well-being between older Western nations and younger non-Western nations. If it were feasible to remove from national statistics all the additional wheelchairs, nursing homes, pacemakers, and medications ranging from Geritol to Viagra-all of which are ways of providing for an older population things which nature provides free to the young-then international comparisons of real income would more accurately reflect actual levels of economic well-being. After all, an elderly person in a wheelchair would gladly change places with a young person who does not need a wheelchair, and so cannot be said to be economically better off than the younger person by the amount that the wheelchair cost-even though that is what gross international statistical comparisons would imply.

One of the usual ways of making international comparison is to compare the total money value of outputs in one country versus another. However, this gets us into other complications created by official exchange rates between their respective currencies, which may or may not reflect the actual purchasing power of those currencies. Governments may set their official exchange rates anywhere they want, but that does not mean that the actual purchasing power of the money will be whatever they say it is. Country A may have more output per capita than Country B if we measure by official exchange rates, while it may be just the reverse if we measure by the purchasing power of the money. Surely we would say that Country B has the larger total value of output if it could purchase everything produced in country A and still have something left over.

As in other cases, the problem is not with understanding the basic economics involved. The problem is with confusion spread by politicians, the media and others trying to prove some point with statistics. For example, some have claimed that Japan has had a higher per capita income than the . United States, using statistics based on official exchange rates of the dollar and the yen. But, in fact, the United States has significantly higher per capita income than Japan when