Basic Economics by Sowell: Chapter 16 – Part 1

This is where Sowell’s thinking really starts to get muddled. From the very beginning, he writes about the monetary contraction that occurred during the great depression, which amounted to the same thing as deflation, which led to wages and prices plunging. Sowell is right enough to say that the market could adjust to allow goods to be sold for less and that it might also adjust so that men would work for less. Everything would go back, more or less, to normal. But, Sowell says this couldn’t happen because the  market could never adjust so quickly.

Of course this is baloney. Markets can turn on a dime if they are allowed. Sowell points out the case of some speculators who bought oil just prior to the Gulf War. The speculators expected the war to last a while and had reserves to sell through, but when the war ended abruptly, and oil production resumed in the Middle East, the speculators were left holding the bag and ended up taking huge losses.

Similarly, when a community is faced with a natural disaster, the prices of generators, flashlights, and the like will go up significantly so long as the government doesn’t step in to prevent it.

Of course, the government was right there when their very own bank crises hit, and they did have controls in place—to keep wages up, to keep prices up. They cut the work force by instituting the social security system that kept wages higher. They also legislated the 40-hour workweek, which did the same, and the labor unions had a big impact as well on the wage costs.

On the price side, all kinds of farm commodities were burned or destroyed. Some millions of hogs were destroyed—not butchered for meat, but destroyed and left to rot, or buried in shallow graves.

The takeaway here is that the depression wasn’t even in part the fault of the market. It wasn’t because the market couldn’t correct fast enough. But, I’m sure we’ll get into the causes of the depression in due time.

This is going to be a rough chapter and we are just getting started. Again, not hard, but it’s a long one, at least from my perspective.

The Importance of Psychology in Economics: JSP – April 1, 2016

So I’ve taken this blog in a little bit of a different direction. For all the fellow fans of the Jason Stapleton show, I’m still listening and I’m still going to point out where he deviates from the Austrian School. It doesn’t mean he isn’t worth listening to, he is probably the best source for news from a libertarian perspective.

At one point, about 30 minutes into Friday’s program, he begins discussing the great depression, and I think he got it all right. There would have merely been a panic as there was in 1819 were it not for the Smoot-Hawley Tariff, and the various other interventions that Jason discusses.

A few minutes into this talk, he brings up a very interesting question; one about psychology and how it has an influence, about what information we receive, how we receive it, and how that makes a difference in what decisions we make.

Jason talks about how the Federal Reserve tries to keep the markets calm and chooses every word very carefully so as not to spook the markets and that Ben Bernanke was giving positive outlooks right up until a week before the housing crash of 2008.

Besides this, he brings up a very interesting question about what Bernanke knew back in 2008. Did he know the markets were going to collapse and keep it quiet? Or, was he caught off guard?  I believe he was caught off guard. I don’t think he even realized we were in trouble until we were well into the recession.  But, that’s a question that we’ll have to try to get into later.

Back to the psychology of things, I think Jason does have sort of a point. If you are an Austrian you’re probably familiar with the master builder analogy. The entrepreneurs in a market are like a master builder, working on building a house, and the master builder believes he has X number of building materials and he is just a buzz of activity building away. Then he realizes he only has X-250 building materials, and he is going to be unable to acquire anymore.  So now, he stops building and panic ensues.  Some have modified this analogy so that the builder is drunk.   Jason gets this, except he doesn’t use the analogy of a builder, but a wounded soldier on the battlefield feeling the distorting effect of morphine. Not nearly as good. The wounded soldier isn’t producing, he isn’t dealing with limited resources, he is just lying there with injuries. Though he isn’t feeling pain that he really should be feeling so he thinks he is okay when he isn’t okay at all. The master builder is producing just like the economy. But, the entrepreneurs in the economy are being deceived by the artificially low interest rates created by fractional reserve banking and the expansionary monetary policies of the federal reserve.

Now, if we suppose that the master builder is drunk, or otherwise has his senses impaired, I think that Jason’s statement has some merit. The builder believes what he is told and keeps building in his drunken state (and yes, you can build things while drunk). But, as soon as he is told the resources are not as plentiful as he thought they were, he panics.

He is intoxicated, as it were, and can’t make out what supplies he actually has through his beer goggles, but is happy to just keep building. He is relying on the interest rates, and what information the Federal Reserve tells him to determine how much material he has to build with.

So, yes, what the people down at the fed say has an impact, but it isn’t because of psychological factors, it’s because, thanks to the actions of the Federal Reserve, the economy is wearing beer goggles and can’t see for itself and is thus dependent on what the fed says about how the economy is doing.

If, for instance, we didn’t have a Federal Reserve people wouldn’t be relying on a financial guru, but would instead look to market indicators, principally the interest rates to determine where the markets are going. Instead, because we don’t have that, the market is relying on every word that comes from the Federal Reserve Chairman.

So, it isn’t a matter of psychological factors, but simply trying to see through the distortions created by manipulations of the interest rate.

Here is an article exerted from Human Action that gives a great explanation.

And, there are two good Tom Woods episodes that discuss the boom-bust:
Episode 118 and Episode 419

Insurance – Part 2: Chapter 14

I really do like his analysis of moral hazard and adverse selection in the second half of chapter 14. Really, about the only thing I would like to see discussed more is case probability vs class probability and an explanation of what probability is. Which actually, Sowell doesn’t discuss at all here. 

He does make a gaff when he talks about how government regulation can reduce moral hazard by restricting dangerous activity. So, the government requiring you to wear your seatbelt cuts down on moral hazard, with the logic being that if you have life insurance or health insurance you are less likely to wear your seatbelt. He doesn’t make this argument precisely, but it is precisely in the same vein and logically consistent with the examples he does give.  He actually uses the prohibition of storing flammable liquids in schools. Why does this need to be a government regulation? He discusses earlier the fact that most insurance companies require dead brush to be cut back away from a building before that building is eligible for insurance coverage. Why should seat belts or flammable liquids in schools or bald tires be any different? If it affects the risk, insurance companies can and do adjust their policies and the price of their premiums. For instance, you pay more for home insurance if you don’t have a fire extinguisher and smoke detectors in your home.  

At best, government regulations have no impact. At worst, they are a detriment. The single exception might be in requiring all drivers to carry liability insurance. This is a problem peculiar to socialized roads. In society with private roads, the owner of the road might potentially bare some responsibility for whatever accidents might occur on its roads. The road owner might insure the drivers; perhaps the cost would be built in, in a similar way that the cost of risk is factored into the price of the car rentals of Hertz, as Sowell writes about earlier in the same chapter. It’s unclear what would happen in a free market. 

Otherwise, the regulations do have an adverse effect, as Sowell goes on to illustrate with the banking industry and the FDIC… something that the Canadian banking system apparently does not have, and I’ve written about this elsewhere. You can see my post on Canadian Banks from March 24th.  Their depositors are on the hook if the bank goes under. This creates market forces where depositors are interested in the solvency of their banks in contrast to American depositors whose accounts are insured by the FDIC. They don’t care at all about the solvency of the bank, so the banks are free, and in a sense encouraged, to be reckless in their business practices. If it works out, they make a lot of money. If it doesn’t work out, the depositors don’t care and the government might bail them out anyway. 

He does a fair job in discussing the differing risks of different classes, and explaining why different groups had different insurance rates. Essentially, an 80-year-old buying a life insurance policy will pay significantly more than a 30-year-old woman seeking to buy life insurance. Not many 30-year-old women die, compared to 80-year-old men. So, the risk is higher among one group than the other and is thus reflected in the price.  

And, I’ll also make a note that he did not, and that Mises did, make that insurance is for the unknown and uncontrollable future events. Yes, it is known we will all die, but it is not known when, at least for most. You can control whether or not you go to the doctor for a cold; you cannot control being admitted to the hospital for appendicitis. If you already have cancer, this is not a future event. 

Sowell finishes the chapter strong ripping on FEMA and explaining that it isn’t insurance at all, which sorta feeds into my last point about the unknown. If you build in a low-lying area that gets lots and lots of rain from time to time, you don’t know when the building will flood, but you can bet that it will be ruined by flood in the next 5-10 years. It is uninsurable. 

If you want a good handle on this subject of insurance, risk, and uncertainty, I implore you to take some time and listen to Chapter 6 of “Human Action” on Uncertainty. You might also listen to chapter 5 on time. I think chapters 5 and 6 can stand alone and provide a masterful explanation of the same things Sowell tried to cover in his chapter.

Stocks, Bonds, and Insurance – Part I: Chapter 14

Early in the chapter Sowell writes, “The fact that interest is paid implies that money today is worth more than the same amount of money in the future.” Worth more to whom? Once again, Sowell deviates from the subjective value theory. Not in a major way, it’s easy enough for an intelligent liberty minded individual to follow where he is going with this, but it’s a mistake an Austrian wouldn’t make, and that I’m frankly surprised to find in Sowell’s work, much less a 5th edition.

The fact that an exchange is made, whether it is a motorcycle for a horse or $100 now for $110 a year from now, shows that the values are inverted. The man with the motorcycle values the horse more than his motorcycle or he wouldn’t make the trade, and the same is true for the man with the horse. He values the motorcycle more than the horse. $100 right now is worth more to the man taking out the loan than $110 later. He has what we call a “high time preference”. The lender values $110 in a year more than the $100 today, this man has a “low time preference”.

Sowell knows this, and it can be seen elsewhere in his writings. This particular section is just a bit unclear, but it is of great importance. Failure to grasp this is what leads to exploitation theory in regards to both moneylenders and employers.

Sowell does well enough explaining how inflation affects the interest rates, but I find it to be out of place since this is “Basic Economics”. And, he discusses how this inflation affects the actual capital gains of stocks or bonds, or real estate. By way of inflation and the capital gains tax, investors can see greatly diminished earnings and possibly even real losses even though they have nominal gains. However, there is no explanation of how the capital gains tax discourages investment. He closes that section of the chapter by noting that some countries capital gains tax is zero while the rate in the U.S. is the center of much controversy. I would expect a brief discussion of what the capital gains tax does to investment; how it pushes investors towards safer investments, putting smaller operations and startups at a relative disadvantage.

I think this needs explanation. So, if I want to buy stocks, I can either make money or lose money. If I lose, I lose. But, if I gain, I only gain the amount that is left over after taxes. If capital gains taxes were at 45% as Bernie Sanders would like, I can put my money at great risk for the chance that it will make 20% in a year, and if it does I really only make 11%. Or, I can assume virtually no risk and get 6%, just over 3% after taxes. What was a 14% gap before taxes has been reduced to less than an 8% gap, without doing anything to mitigate the risk. Bernie Sanders, by increasing the capital gains tax, essentially favors large companies over smaller companies.

I’ll wrap up with that and pick up Insurance tomorrow.

Basic Economics: Thoughts on Chapter 13

I started this series more or less with chapter 12. I did externalities, which come later in the book based on a request, and if anyone wants commentary on any particular subject Sowell covers, feel free to let me know and we can skip around.

I’ve gone back and skimmed through the first 11 chapters and didn’t see anything that was glaringly wrong or any major omissions. And, that is sort of how chapter 13 is.

Chapter 13 is titled Investments. What I like about Sowell is it puts things nicely into context. In addressing the seemingly astronomically high rates of interest of a payday lender, I think a lot of Austrians would confine themselves to arguing principles. Basically, if you really want that new lazy-boy, or if you’re not smart enough to save up or find some other way of getting a loan for $450 dollars… and you have to have the money today, well then it’s your funeral! You ought to be free to do whatever you want. I can see Walter Block pointing out the fact that the payday lenders are the only people who will lend to some people, so why should the media be upset that the payday lenders are charging 72% interest? Shouldn’t they be upset with the banks who won’t lend to these people at any rate whatsoever?

On that first point, I think Sowell would have done well to cover this; you can never go wrong arguing principle. But he does redeem himself by coming back and pointing out that payday loans are not carried for a whole year so annual percentage rates are irrelevant. It’s like saying a hotel room rents for $36,000 a year. Unlike our more principled arguments, this one makes our opponents look silly. And, I like it when statists look silly.

I’ve got to touch on “unearned income”. Who says whether or not income is earned? First off, Sowell, when discussing investments such as stocks that pay dividends, he says the income was earned, but that it was earned in the past, possibly years ago, and is only now being paid out. I’m not as convinced of this within the whole framework of the concept… I can agree, but I don’t find it sufficient to convince our opponents. Rather, realize that income isn’t the result of earnings, you don’t “earn” your money like you “earn the right to ride your bike as a kid”! Instead, you trade for your income. All honest income, and even some dishonest income, is traded for; whether you trade your crop, or your time digging a ditch, or your brainpower in figuring out how to keep 100 tire machines from running out of components. OR, your money in the past for more money now! Everything is a trade. What difference does it make what the specifics of the trade are?

Surely chapter 13 is no work of Mises, and I could probably slice and dice it, but I don’t think that’s fair, and I’m out for big game. He hasn’t yet gotten to time preference when discussing interest rates; it doesn’t play as big of a role for him as it does for us Austrians, but I think he does discuss it later in his book.

OH and I should touch on speculation. Sowell, once again, does a great job explaining how speculators aren’t just gamblers. They do not create risk like dice players do. Instead, they manage the risk inherent in life for others, such as farmers. Someone is going to have to speculate, so they specialize in it, relieving other people from the headache of the burden!

See guys, Sowell isn’t all bad!