Sowell’s Basic Economics: Deflation, Part One

Note: Though there are still a lot of errors and misrepresentations in this short section (pp. 373-378), it is not nearly as convoluted as the one on inflation. So we are going to take our time and enjoy this.

On page 373 Sowell writes, “From 1873-1896, price levels declined by 22 percent in Britain, and 32 percent in the United States … output was growing faster than the world’s gold supply. While the prices of current inputs and outputs were declining, debts specified in money terms remained the same – in effect, making mortgages and other debts more of a burden in real purchasing power terms than when these debts were incurred.”

First, it should be noted that the Western world was on the Gold Standard and the money supply was not shrinking. In other words, no deflation was occurring. Inflation and deflation, in a technical sense, refer only to the supply of money increasing or decreasing.

The most important thing about the money supply is that, ideally, it does not change. If it does change, it should neither increase nor decrease by very much, very quickly. There is no real optimal supply level. If newer techniques of production and better tools are invented which push down the costs of production and thereby put downward pressure on the prices of consumer goods, this ought not to be seen as a bad thing as it demonstrates than man is making advancements in his struggle against scarcity.

Now let us address the debt issue. Over the 23 year period from 1873-1896, prices fell by 32% in the United States. That is an average drop in price of 1.4% per year and is far more stable than 2% inflation per year that we experience today.  The fact that prices were falling and the overall purchasing power of the dollar was increasing put pressure on debtors to make extra payments toward their debts and pay them off or avoid going into debt unless it was unavoidable. Contrast that with today’s economy where the money is losing purchasing power and most people are in debt as a lifestyle. Debt is now a cultural norm. With the dollar losing its value at about 2% a year, it almost makes sense to buy everything you can on credit.

Have you heard of time preference? The basic idea is that – all things being equal – supposing there is not any interest and the values involved are perfectly stable over the allotted time, a man will prefer a good sooner rather than later. It is more desirable to have a it all now: a candy bar today rather than a candy bar tomorrow, a laptop next week rather than a laptop next month, a new car next month rather than next year. As the saying goes, “There is no time like the present.” When the value of money is decreasing the way it is now, inflation magnifies the time preference and makes it even more acute. Not only would I prefer a new car next month – heck, right this minute – but why should I hold my savings in the bank where it is losing value while I continue to save toward the future purchase of a new car? Next year a new car will be more expensive than the one on the lot today and my money will be worth less. I would rather use any savings as a down payment and take out a low interest loan to cover the rest.

On the other hand, when the money is increasing in value relative to the price of goods and services this usually has a tempering effect on time preference. The consumer will look at the car market and determine that though he might like to have a car right this minute, the wise thing is to continue saving his money. The money saved will be worth more in a year or two and the price of the new car will be even lower than it is now. 

As far as debts being more of a burden, there is some truth to this, but those already in long term debt can always refinance to more favorable terms or buckle down and pay off their debts early. 

While something in the amount of the average mortgage would be a pain in such circumstances, it would also be much easier to save and buy a home with cash, or with a greater down payment than what anyone approaches today.  Besides, a fellow locked into a mortgage in a “deflationary” economy could be said to be paying more in real terms. We should not forget that everything else he has to buy is getting cheaper.

Sowell finishes off the paragraph by saying, “Farmers were especially hard hit by declining price levels because agricultural produce declined especially sharply in price, while the things that farmers bought did not decline as much, and mortgages and other farm debts required the same amounts of money as before.”  

There is only an inkling of truth to this. You need to consider the time that separates investment from return. A man might spend money today, in 2016 prices, to buy apple trees and then have to wait 4 years before his first crop of apples appears that he will then sell at 2020 prices. In a deflationary setting the farmer may be said to lose money, but apples may have been one dollar a piece when he planted the trees and only 90 cents a piece the first year he sold his crop. The purchasing power of the 90 cents was the same when he sold as one dollar was four year earlier when he planted.  When you look at what his money would exchange for on the market from one time to the next, not much has changed.

Nevertheless, times were hard for farmers in this era and that has to do with tariffs. Tariffs were extremely high in this era, and it was these tariffs and not an appreciating dollar that put a burden on farmers. I have written on tariffs in previous posts, but I think they will get covered again as we work through this book.

See you soon.

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.