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March 29, 2009

Book Review - Basic Economics

Of the many authors whose books I've read over the years, Thomas Sowell is probably my favorite. Certainly that would be the case if you looked at my bookshelf, because I have more from him than any other author.

The reasons for this are many; Sowell is an unusually clear writer, he writes on a variety of subjects, and his research is impeccable. Rather than the "extended editorial" we get from so many populist writers, when you read a book by Sowell you'll find footnotes on every page. If you follow them you'll find they're usually from other scholarly works as well.

Another thing that attracts me is his world-wide perspective on just about any topic. The examples he uses in Basic Economics come from all around the world, and this is typical of his writing. To gather his data Sowell personally travels around the world and interviews scholars, businessmen, and political leaders.

Given that the economic crisis is the biggest thing happening, I figured I'd better bone up on the subject. I stated out with Henry Hazlitt's Economics in One Lesson, a short treatise promoting free market economics. It's a good primer, but without much depth. And although he is mostly right, one has to admit that Hazlett was not trained as an economist.

The same certainly cannot be said of Thomas Sowell. Educated at Harvard, Columbia, and the University of Chicago, he has a Ph.D. in Economics from the latter. After having been an Associate, Assistant, and full Professor at some of the most prestigious institutions in the country, he is currently the Rose and Milton Friedman Senior Fellow at The Hoover Institution at Stanford University. Over the years he has authored a couple of dozen books on a variety of topics, including of course economics.

None of this automatically makes Sowell right. There are plenty of people with fancy degrees who are wrong in their areas of expertise. What it does is lend some background so that when you read Basic Economics, you at least know you're looking at something written by someone trained in the subject matter he's writing about.

As with Hazlitt, Sowell is a conservative free market economist of somewhat libertarian bent. As such, you can expect that many or most of the lessons in his book revolve around his basic world view.

As the title implies, Basic Economics was written by Sowell for the average person who has no particular knowledge of technical economic terms. There is no jargon, no graphs or tables, and no equations that you'll find in textbooks. While it is footnoted liberally, for a book on "the dismal science" it is a surprisingly easy read. What helps keep it interesting is that Sowell uses some very interesting examples from business history to make his points.

For example, did you know...

That White Castle was the largest hamburger chain of the 1930s, with almost as many stores per capita as McDonalds has today?

That A & P Grocery was the Wal-Mart of the 1930s and 40s, because it drove so many mom 'n pop grocery stores out of business?

That James Cash Penny made his fortune because he studied the 1920 census?

White Castle made a fortune because they located their fast food outlets near factories in cities, giving them direct access to a huge market. All their stores were company owned, which gave them a decided advantage over a franchise chain during the Great Depression because a profitable store could subsidize an unprofitable one. But in the 1950s, the great era of factories ended, and workers moved to the suburbs and other types of jobs became more common. White Castle was slow to respond. Ray Croc operated McDonalds on a franchise model, which could grow more quickly than a model in which the company owned all the stores. His franchise stores were mostly in the suburbs, which is where the action was. We know who came out on top.

Before the automobile, it was hard to carry much home from the grocery store, and in any event the range of a horse and buggy was limited. As a necessity grocery stores were mom 'n pop affairs on every streetcorner. The owners of A & P saw how the automobile changed how people could get around, and so they developed the idea of the supermarket, which was so efficient it drove the smaller stores out of business. For a few decades A & P ruled the grocery business, yet was widely despised. In the 1950s the upstart Safeway located it's stores in the suburbs. A & P, whose stores were mostly in the cities, didn't initially put any stores in the suburbs because of the high cost of real estate there. Before long urban decay destroyed A & P's profitability, and the chain is a remnant of the giant it once was.

In the late 19th century Montgomery Ward and Sears Roebuck and Company made a fortune in the mail order business. They were the Amazon's of their day, selling everything from books to bicycles, to furniture to sewing machines to people all over the country. Instead of websites they had lavishly illustrated catalogs. This model worked because most Americans lived in the country, and the economics of large physical stores didn't work out. Then one day a guy named James Cash Penny studied the 1920 census, and realized that for the first time more Americans lived in urban areas than rural ones. He saw that the time for large physical department stores had come, and he built a chain of them. He almost drove Montgomery Ward and Sears out of business before they realized what was happening and hurriedly built their own stores.

These are just a few of the stories Sowell uses to illustrate his points. Many are from other countries, in particular India. Before 1991, business in India was tightly regulated.
A change in government allowed some losening of restrictions, and Sowell uses this to show how the resulting growth benefited more Indians.

Following are a few of the principles of economics that Sowell explains in his book. There are many, many more, so please understand that this is just a brief sample:

Price Controls

Scarcity means fewer goods available relative to the population, while a shortage is a price phenomenon. The earthquake of 1906 destroyed thousands of housing units, but there was no housing shortage because people immediately put extra rooms and buildings up for rent. These people did not do this out of the goodness of their hearts (in most cases, anyway), but were entrepreneurs who saw the chance to make money. As such, although 200,000 had their housing units destroyed, no one was forced to live on the street except for the shortest period. Likewise, Sowell explains how the gasoline "crisis" of 1972 and 1973 was entirely created by the U.S. government and did not reflect a shortage of product.

Complex effects can have very simple causes. For example, it is a simple concept that people buy more at lower prices than at higher ones. It is also simple to understand that producers will make more of something if they can sell it for a higher price than at a lower one. Price controls are also a simple concept. But if you put them all together you get all sorts of complicated reactions, most of which were not what was intended.

Rent control is the most prevalent attempt at price control by well-meaning people that has led to many problems, many of which were directly counterproductive to what the lawmakers intended. Sowell uses examples from Sweden, New York City, Australia, and other places to make the point. Sweden was the most illustrative. After World War II, Swedish lawmakers inposed rent control. With prices low, demand skyrocketed, especially as incomes increased in the post-war boom. No matter how fast they built housing units, the waiting list got longer and longer. Housing units were not scarce in any meaningful sense, but there was a shortage (remember our definitions). Finally, Swedish lawmakers abolished rent control, and prices went up to their natural level. As soon as they did, the waiting lists disappeared. There was neither a scarcity or shortage of housing units.

Other effects of rent control in a capitalist system is to reduce the incentive to build new housing units, and to maintain existing ones. It also incents builders to construct luxury units for the wealthy, since lawmakers almost always make a few exceptions in their legislation. Finally, rent control incents tenants to occupy a larger unit than they would otherwise, since prices are kept artificially low. The net effect is to create a housing shortage.

The concept of Cost is part of this discussion. Prices are not arbitrary, and serve the purpose of forcing people to make choices between scarce products (something is scarce if it isn't available in unlimited supply, such as air, and with pollution that's scarce too). Schemes by well-intentioned people to make things "more affordable" or a "right" ultimately run up against economic reality. Prices are not just a nuisance to get around, Sowell says, but reflect scarcity. Thus it may make some people feel morally superior that they make health insurance a "right," but the always ignore the effects on supply and demand while making their speeches.

Eliminate the Middleman

I think we're all heard the commercials that end with "and what did they do with the middleman, anyway? Something fishy there...." While this makes for a good commercial, it never really works out that way. Farmers are never going to truck their own eggs to the supermarket. Ranchers won't butcher their own stock and can their own stock. Newspapers don't own and operate their own newsstands, and automobile companies discovered a long time ago that it's cheaper to let someone else sell the cars.

There are more middlemen in Third World nations than in industrialized. Far from reflecting inefficiency, it is more efficient in underdeveloped economies to have more intermediaries. Sowell explains in some detail why this is so, but essentially it is because the quantities produced by farmers working small plots is less than in the West.

Metrics

It can be much harder to measure things like efficiency than one might imagine. Sometimes it's relatively straightforward. For example, European farmers brag that they produce more product per acre than their American counterparts. American farmers brag that they produce more per agricultural worker than their European counterparts. Both are factually correct. Who, then, is more efficient? Both, and neither. Each has tuned their efficiency to their own circumstances. Europeans have a shortage of land, Americans, labor.

Other times it is more difficult. During the Cold War, Soviet propagandists bragged that their railroad system delivered more goods per railcar than their American counterpart. And they were right. Did this, then, mean that their system was more efficient? No, because they were using the wrong metric. A better measure of efficiency is whether products get to where they're supposed to be when they're supposed to get there. By this measure, the American system was clearly superior. After all, we're all familiar with stories of Soviet agricultural waste because perishable products rotted before they were delivered. That the American system required more railcars is immaterial.

The Scarcity of Knowledge

A theme among free-market economists is the impossibility of central planners to have enough information to control any aspect of an economy. Frederick Hayek expounded upon this in The Road to Serfdom over 50 years ago, and Sowell continues the tradition in his book.

An interesting example Sowell uses is from 19th century Rhodesia. The British government decided that they knew best how to grow peanuts in Rhodesia, and so micromanaged the process from London. They turned a profitable enterprise into a disaster in just a few years.

In addition to this somewhat exotic example, Sowell uses much from everyday American life in his discussion of the concept of how knowledge affects economic decisions and the perils of government control. Everything from the ability of a literary agent to know the price of a manuscript to a real estate agent understanding the local housing situation are used.

Rich v Poor

Workers and salaries are supply and demand by another name. The same principles of supply, demand, and price apply to workers and their salaries. Demagogues may talk about "exploitation" and demand a "living wage" all they want but they cannot overturn the laws of economics.

We often hear in the press about how the rich are supposedly getting richer and the poor poorer. The term is usually "income inequality." The message is that we are are an increasingly stratified country and that something must be done.

The problem with such studies, Sowell contends, is that they tend to simply compare the income of those in the top 10-20 percent with those in the bottom 10 or 20 percent. What they almost always miss is that people are constantly moving in and out of each bracket. In fact, an absolute majority of people who started out in the bottom 20% in 1975 ended their lives in the top 20%.

"Rich versus poor" thinking also tends to be zero-sum. This is the fallacy of thinking that one person's gain is of necessity another's loss. Although it is rarely stated this way, that's what it often amounts to. What it does is assume that the economic pie is of a given size and does not increate

Speculators

A year or so ago when oil prices spiked, some on the left were telling us that it was all the fault of evil speculators. The message was that there were a group of people manipulating prices in order to make massive profits for themselves at the expense of the common person. Something, we were told, must be done. Typically that something was increased regulation.

Sowell explains speculation in more dispassionate terms. He explains how speculation is not only vital to a functioning economy, it benefits both producers and suppliers.

Essentially, a speculator is someone who buys or sells at a fixed price today for a product to be delivered at a later date. What this does is shift the risk from the producer and consumer to a middleman. The benefit to the parties at each end is that with an assured price their own planning is much simpler. Further, as they are not specialists in the price market or worldwide conditions, they can concentrate on what they do best. This holds true even since the speculator makes money.

Suppose we have a farmer who wants to grow potatoes. He does not know what the price will be at the end of the growing season, and doesn't know much about the potato exchange either. But he does understand farmer. His best course is before he's planted his first potato to go to a speculator and sell the entire crop at a fixed price, one at which he is certain to make a profit (otherwise he switches to a different crop). The speculator is hoping to sell the potato crop at a rate higher than he bought it from the farmer, but of course he may end up selling it at a loss. Because the speculator has reserves (or should, and here is where regulation comes in), he can bear the brunt of a loss without short-term pain.

Note that neither me nor Sowell are against regulation. What we're against are people who prefer to demagogue issues rather than understand the underlying economic principles.

Money and the Banking System

At one time American currency was redemable in actual gold or silver. We were said to be on the "gold standard" as the amount of money in circulation could not exceed the value of the gold in Fort Knox.

It was said that our money was then "backed up" by gold, but this was somewhat misleading. The value of the gold was not somehow transferred to t he paper currency, rather all it did was limit the amount of money that could be in circulation. The reason for taking us off the gold standard was so that the government could issue more money.

The Role of Government

As mentioned earlier, Sowell, like all free market economists, is not somehow against government regulation. Indeed, it is vital to the functioning of an economy.

Even maintaining basic law and order counts for a lot. What we take for granted took millenia to achieve. Further, "law and order" means "white collar crime" as well. An economy can fall apart just as fast if those at the top are allowed to violate laws just as much as if armed gangs are allowed to rule the streets. As such, laws must be easy to understand and reliably enforced.

The dependability if its laws was one of the primary reasons why noneteenth-century Britain was able to leap ahead of it's European competitors, and indeed the rest of the world. The dependability of their laws are why so many third-world nations remain mired in poverty despite both natural resources and foreign aid.

Sometimes economic decisions made through the marketplace are not better than those made by government. For example, a side effect of a coal power plant is air pollution. The people who bear the cost of the generating process is born by people who are not directly involved in the process. Breathing dirty air results in increased medical costs, which in an unregulated situation would not be paid by the utility company. These are called "external costs" by economists, and are the cause of legitimate government regulation, because only it can make decisions efficiently.

The flip side of "external costs" is "external benefits." Making truck companies put mud flaps on their vehicles does not help them, but those who are behind them on the road. Again, we have a reason for legitimate government regulation.

More and More

All this said, we have to recognize that there is a point of diminishing return to such things. Reducing air pollution is all very fine, and it is easy and cheap to get rid of the first 95% of particles from a cola plant. Getting rid of each additional percentage point costs more and more. We have to recognize that there comes a point where the cost exceeds any reasonable benefit.

It is a fallacy that American goods cannot compete because of low-wage earners in third world countries. Historically, high-wage countries have had trade surpluses with low-wage countries. The economic flaw in the argument is that it confuses wage rates with labor costs, and labor costs with total costs. "Wage rates are measured per hour of work, while labor costs are measured per unit of output. Total costs include not only the cost of labor but also the cost of capital, raw materials, transportation, and other things needed to product output and bring the finished product to market." In actuality, high-wage nations have three times the production per hour of low-wage nations.

"Dumping" of cheap products is often used as a justification for protectionist measures, but the argument doesn't stand up to scrutiny. In fact, Sowell says, it has proved impossible to accurately calculate the cost of production in a foreign country, as has been admitted to by the US government. Further, all countries both indirectly or directly subsidize or help various industries, and all impose restrictions of one type or another in imports. Ratcheting it up only results in a trade war of tit for tat.

Economic terminology can be confusing and even misleading. This is particularly true when saying that a particular currency is "strong" or "weak." A "strong" dollar simply means that its value is rising in relation to one or more other currencies. A strong dollar will buy more units of a foreign currency than previously. A weak dollar will buy less. Whether this is good or bad depends on your point of view. A weak dollar means that it takes more dollars to purchase the same amount of foreign currency that it did earlier, and vice versa for a strong dollar. A strong dollar is good if you are buying foreign goods, but bad if you are exporting American goods to other countries.

Economics is not a value system, but simply a means of weighing one value against another. The study of economics does not say whether rent control is good or bad, only what will happen if you impose it. Adam Smith, the father of laissez-faire economics, gave most of his money to charity when he was alive.

The term "greed" is thrown about often but is rarely defined. Ironically, it is often those who set out to make the most money for themselves that end up providing a new product or service that lots of people want, or find a way to make an existing profit at lower prices. Indeed, "lofty talk about 'non-economic values' too often amounts to very selfish attempts to have one's own values subsidized by others."

We also hear much talk about "predatory pricing," especially with regards to large retailers who drive smaller higher-priced rivals out of business. However, there is precious little evidence that this really exists. Both A & P Grocery in the 1940s and Microsoft in the 90s were accused of predatory pricing, both without a single solid piece of evidence.

Conservatives are often accused of promoting "trickle down" economics, but it simply isn't so, because the theory has never existed among economists. Sowell writes that

People who are politically committed to policies of redistributing income and who tend to emphasize the conflicts between business and labor, rather than their mutual interdependence, often accuse those opposed to them of believing that benefits must be given to the wealthy in general or to business in particular, in order that these benefits will eventually "trickle down" to the masses of ordinary people. But no recognized economist of any school of thought has ever had any such theory or made any such proposal. It is a straw man...

Proposals to reduce taxes on capital gains, for example, are often opposed politically by saying that those who make such proposals believe in a "trickle down" theory of economics. In reality, economic processes work in the directly opposite way from that depicted by those who imagine that profits first benefit business owners and that benefits only belatedly trickle down to workers.

Rather, when an investment in a business is first made, the first thing done is to hire people. Capital is spent on buildings, plant, equipment. This obviously benefits those receiving the money. Only years later do most businesses turn a profit. The profit, then is at the end, not the beginning, of the process.

Economics has been called "the dismal science" not because it is boring but because it tends to throw cold water on the schemes of do-gooders. Sowell does an excellent job of explaining why this is so in Basic Economics, and does so with clear writing and without the technical jargon. It is a book recommended for everyone who wants an understanding of fundamental economic issues.

Postscript to the Review: A Note on "Faith in Free Markets"

We on the right are often accused of having "faith in free markets," and sometimes the accusation is true. It usually misses the point, though. As Ramesh Ponnuru recently explained in the most recent print edition of National Review

..."faith in the market," even when taken too far, as it can be, is generally not faith that some group of people have all the right answers. it is confidence that trial and error,k feedback loops, competition, and decentralized knowledge will come closes and closer to the right answers. Friedrich von Hayek's Nobel lecture urged policymakers to emulate gardeners rather than engineers, creating the environment for growth rather than trying to bring it about directly.

Posted by Tom at March 29, 2009 10:00 PM

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Comments

Clear writing reflects clear thinking, and Dr. Sowell's writing is refreshingly clutter free. You may enjoy reading this related post of mine from a couple of years back:

Bloggers are "cracking, popping, drilling and peeling their victims open"

Posted by: Sissy Willis at March 31, 2009 7:32 AM

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