Introduction
Introduction There are two kinds of economists: Those who think the free market always works, except when the results don't suit them; and those who think the free market never works, except when the results do suit them.
In my view, the free market always works. Whether the results suit me or you is a matter of taste, and if we don't like the results, we can change them anytime, just by adding our money to the market. The best thing about economics is the free market, and the best thing about the free market is freedom.
In this book, I am attempting to provide intelligible advocacy and explain economic issues, and I offer some historical background for the topics in each chapter.
I'm throwing out all the charts, graphs, and technical terms, throwing out the mathematical analysis, throwing out game theories, and throwing out professional economists. What remains is a way of looking at the world through the powerful lens of capitalist investment and productivity.
This book cannot give you all the answers, but I hope that after reading it, you will be ready to have interesting conversations with other intelligent people interested in politics, business, and history. If you take the lessons of this book to heart, you should be ready to have warm and vigorous conversations, for the ideas here are controversial. Many well-meaning people would rather impose their ideas on others for their own good; they recoil at the idea that people should make their own choices, for better or worse. The consistent philosophy in this book is that free markets are effective—capitalism provides superiorsolutions to most of our looming problems. Even more important, free markets and capitalism are good because they promote individual liberty.
Economics has been called the "dismal science," and there's plenty going on in the world that supports that charge. Poverty and the unequal distribution of wealth, the population explosion, trade conflicts, immigration, outsourcing, environmental damage, rising energy prices, uncertain health and pension benefits, and many more discouraging economic issues push their way onto our computer displays, television screens, and front pages every day.
The phrase "dismal science" was coined by Thomas Carlyle, the nineteenth-century essayist, in a retort to the forecasts of Thomas Malthus, an economist who projected that the earth's food supply could not grow as fast as its population; hence, humanity is doomed to suffer frequent famines.
"Dreary, stolid, dismal, without hope for this world or the next," said Carlyle of the Malthusian prophecy. He also applied the whole phrase "dismal science" to his own economic argument in 1849 that freeing the slaves who worked the West Indies sugar plantations had not been in the slaves' best interests. Carlyle said that, without plantation owners' capital and enterprise, the best the former slaves could do on their own was subsistence agriculture and fishing. Sugar had been more lucrative and life as a slave had been more secure, he claimed.
Dismal science, indeed, if it were true. Man, however, does not live by bread alone: A hungry free man is better off than a well-fed slave. In this book, we explore some hard questions about capitalism and humanity. It's true that economics sometimes turns up some distressing conclusions because it is the science of human behavior stripped of all illusions. Economists observe what people do for money; it is often not a pleasant sight.
Capitalism is business, and the study of capitalism is the study of the sources and uses of profits—how money becomes wealth.
Although some historians consider capitalism to be a form of social organization, all forms of social organization are based on the concentration of wealth for investment, and societies prosper on the returns of their investments.
Studying capitalism should eventually produce an awakening like that of the Moli_re character who discovered he had been speaking prose all his life without knowing it. When we talk about the creation, distribution, and consumption of wealth, we are talking about capitalism, whether we believe in it or not.
Supply and demand are the chief forces in economics. Demand is always infinite and supply never is. We would all like to gorge ourselves on our favorite things, but they are not infinitely available. Prices are set by the availability of things—supply—and the combined desires of people to have certain things in preference to other things—demand. Supply and demand are hard to measure because they don't stand still. For each product or service in the global economy, supply and demand are constantly changing according to the needs and desires of billions of people. Large imbalances between supply and demand also occur, creating general price inflation or deflation. Economics theorists talk about "equilibrium," the point where supply and demand are in balance, prices are stable, and supplies are predictable. It is a wonderful mathematical exercise, worth many Nobel Memorial Prizes in Economic Science. But as Yogi Berra might have said, "The difference between theory and practice is that in theory, there is no difference, but in practice, there is." Any person interested in economics must understand that prices constantly change with the preferences of buyers and the availability of parts, labor, and capital (all of which also have prices set in markets).
Value is a different concept from price. There is no such thing as an intrinsic value of goods or services. Value in an economic sense is nothing but a price set in a market. It changes constantly.
Creating Capital The origin of wealth lies in scarcity. Anything we can have without effort has no value. When we must work to hunt, mine, farm, when we buy tools and sell products, and when we must defend our gains, we establish an economy, an interrelationship of many people. As quickly, we become capitalists—owners of tools, large or small. Day laborers who own their shovels are in that small sense capitalists, just as owners of factories or farms are capitalists with more physical capital. We also work to acquire skills that can be termed human capital.
Goods and services are made and provided from ingredients, sometimes called the factors of production. The classic description of these ingredients is land, labor, and capital. Land is more than just a field—it stands for the resources of the earth, from mining to agriculture. Labor is more than the sweat of our brows—it stands for all forms of energy use. Capital is more than just money or wealth—it stands for tools, machinery, and knowledge.
Any product and nearly all services require judicious mixtures of all three, so management should be counted as a fourth factor of production. It is the human talent involved in combining the other three.
A farmer works the land using capital equipment, such as a plow, horse, or tractor, and seed. He is more productive if he knows how much seed is enough, how deeply to plow for the particular crop, how hard to work the horse, how much to feed him, and countless other variables. Even a peasant must manage complexity.
Available resources have changed over time as technology pushes the limits to growth. From horses to tractors, from seed gathered and saved to seed genetically engineered and sold at the farm dealer, from rain to irrigation, from manure to chemicals—every aspect of production changes because of technology.
Changes in social organization also affect the optimal allocation of land, labor, and capital. Sharecropping leaves little incentive to make permanent improvements; the growth of banking and credit make land more affordable; insurance and futures markets make ventures less risky; education makes farmers more skilled. The study of such forces may be the most serious, and certainly the most difficult, part of economics.
The 80-20 Rule In any society, there will always be more followers than leaders, more losers than winners. An 80-20 rule seems to govern human affairs: Left to their own impulses, 80 percent of the work is done by 20 percent of the work force; 80 percent of property falls into the hands of 20 percent of the populace; 80 percent of the effort produces 20 percent of the value. Economists call it Pareto's Law, after Vilifredo Pareto, a nineteenth-century Italian economist who noticed 20 percent of Italians were earning 80 percent of the national income.
Here are some other examples of the 80-20 rule:
Twenty percent of the devices, tools, and people on an assembly line are responsible for 80 percent of the defects.
Twenty percent of the customers account for 80 percent of the profits. Also, 20 percent of the products and 20 percent of the sales force generate 80 percent of the profits.
Twenty percent of the customers—a different 20 percent— also make 80 percent of the complaints.
Workers who can schedule themselves—such as artists, writers, or senior office workers—get about 80 percent of their work done by working intensely about 20 percent of the time.
Twenty percent of hospital patients and 20 percent of health insurance clients account for 80 percent of the costs of care.
Much derided and denounced, "trickle-down economics" refers to the concept that if the 20 percent who create wealth are left unfettered and lightly taxed, they and their investments will create more wealth, so the benefits will trickle down to the rest of society in the form of wages and profits. This should not be controversial; it should be taken as a fundamental principle of capitalism.
That's what it seemed like to Adam Smith, who noted that the wealthiest person cannot eat much more than anyone else. The rich man's food may be more artfully prepared, better decorated, served by a waiter in a fine uniform, or composed of more courses. Still, a meal is just a meal, and one can eat only so much.
In Smith's view, all the other trappings of wealth are conduits for trickle-down economics: If the wealthy diners were not wealthy, their chefs and sous-chefs might not be employed, their well-paid cake decorators might be baking cookies at home and selling them on the street, their waiters and the rest of their household staffs might be subsistence farmers. None of them could earn as much in such circumstances as they could on an eighteenth-century nobleman's estate. (That does not stop the servants from resenting their stations in life or from looking down on those not so well employed.)
Far more important but less visible, wealthy individuals invest their wealth in productive enterprises, which also employ factory workers, salespeople, executives, and janitors. Wealth does not merely trickle down—it gushes in cataracts and nourishes the entire society.
As Smith said of the rich, "They divide with the poor the produce of all their improvements."
In modern times, trickle-down economics burst upon the American political scene in the early days of the Reagan administration as a derogatory term for radical tax cuts, especially cuts in high progressive tax rates on high incomes. In 1981, the highest bracket of taxable income was taxed at 70 percent, although few people paid taxes at that rate because the tax code also offered many tax shelters.
Tax-cutters rarely dare to use the term trickle-down economics, although in one incident, President Reagan's budget director, David Stockman, privately conceded that his "supply-side economics" was really trickle-down economics, and the concession made it into a book that was published while the tax-cut controversy was still lively.
The debate was in two parts: Was it true that Republican tax-cutters wanted to cut rates on the rich? And was it true that cutting high tax rates on the rich would stimulate investment, create new jobs, and bring benefits to lower income classes?
Both things were true, although the effects take time to work their way through the economy, and other factors also operate. Some Democrats, however, believed trickle-down economics was a cruel hoax and the benefits for the middle class and the poor were nonexistent.
Republicans rarely come out well when Democrats accuse them of favoring the rich, and thus they rarely defend trickle-down economics well. They ignore it or run away from it as much as they can.
They should be casting the alternative in terms people can understand. The point of high tax rates is to take wealth away from individuals who have a lot of it, never mind that most of it is invested in the productive economy, where the returns on the investment are trickling down to everyone. Most government spending, however, is just spending—pure consumption that does little to create new wealth.
Democratic government has this fundamental problem: In broad terms, 20 percent of the people do most of the productive work and create most of the nation's wealth, but the other 80 percent command a heavy majority of votes. It's a pleasant surprise that democracies foster much investment and productivity growth at all.
The Power of Productivity Economic productivity is something for every member of society to celebrate. When productivity is rising in a society, wealth is being created, and more and more wealth is available—through the trickle-down effect—to satisfy the wants and needs of the whole population. However a society chooses to divide its output, productivity drives output upward. There's nothing more important for the economic well-being of any society.
Labor productivity, however, is often misunderstood. It has little to do with how hard the work force labors. It actually measures the power of capital: Capitalists acquire the land necessary for their enterprise. Capitalists select the sources of the enterprise's raw materials. Capitalists borrow money or sell shares in the enterprise so they can make these investments and hire workers. (Or capitalists hire managers to do these things.)
When workers take their tools from the owner of the enterprise, use them according to the owner's direction, and become more productive than they could be on their own, their labor productivity increases. (Their labor productivity might also increase if they work harder each hour, if they bring their own, better tools to the factory, or if they acquire more training or education and learn to work smarter and more efficiently.)
Many economists separate out such intangible factors as advancing technology, innovation, managerial skill, luck, and organizational change and call these the fruits of total factor productivity, not of capital alone. Those who study this kind of productivity say that more than half the advancement of U.S. productivity since World War II has been the result of these intangible factors. But capitalists should get most of the credit for introducing new work methods as much as for purchasing new machinery.
For a simple example, suppose a furniture manufacturing business has been hiring skilled painters to brush-paint its products. The boss buys some paint sprayers, which are easier and faster to use. Almost immediately, the painters can paint 50 percent faster, with results that are just as good. Any student of productivity would consider this a case of capital deepening, in which the advancement of output is due to the increase of investment in capital equipment. Over time, the workers become more skilled with the new equipment, learning, for example, that they can layer several coats of paint without waiting for each coat to dry. The factory owner also rearranges the work floor so that the spray painters have easier access to the work they are painting. Output rises again, even though there was no further investment in capital equipment. This may be called an increase in total factor productivity, but it should be credited to the original capital investment in paint sprayers.
There are three ways a nation can enjoy more income, three ways to make the economic pie get bigger. First, more people can go to work: A country might encourage immigration to fill newly created jobs. Second, people can acquire more skills: A country might open educational opportunities to women, easing their entrance to highly paid professions. The United States has used both methods in recent decades, but they are not indefinitely repeatable opportunities. The third way is to encourage people to invest in plant, equipment, and organization. The third way is harder, more expensive, and potentially unlimited.
An important reason economics has been called the dismal science is that its honest practitioners offer so little comfort to politicians and other wishful thinkers. A dollar spent on ice cream won't be available later to spend on meat and potatoes. That's hard enough to accept, but here's something worse: Dollars spent on wages won't be available later for the business to purchase new equipment or build new factories, so later there will be fewer jobs, and fewer well-paying jobs, than there might have been had the boss paid less. Many of our leaders would prefer to tell us something else—that businesses can spend more money on wages and benefits and still have enough profits to create more jobs, or that corporate profits and individual capital gains can be cut or taxed without harming investment and productivity.
What is really dismal is that so many economists are ready to feed the fire of political redistribution. Reckless economists advise politicians to favor consumption over investment, labor over capital, and jam today over meat and potatoes and jam tomorrow.
The pursuit of productivity and wealth requires more self-restraint and more determined investment in the pursuit of profit. In the following chapters, we examine the continuing conflict between consumption and investment.
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