Friday, February 1, 2008

Economics in One Lesson

I took a break from The Road to Serfdom to read Economics in One Lesson by Henry Hazlitt. I am told that if you only read one book about economics, this is it. I am about one quarter into it and so far I agree. I highly recommend it. You can even read an older edition online.

The book focuses on how most economic misconceptions arise from people seeing only what is visible and salient and missing the unseen unintended consequences. It begins with the Parable of the Broken Window:

A young hoodlum ... heaves a brick through the window of a baker’s shop. A crowd gathers ... After a while ... several of its members are almost certain to remind each other or the baker that, after all, the misfortune has its bright side. It will make business for some glazier. As they begin to think of this they elaborate upon it. How much does a new plate glass window cost? Two hundred and fifty dollars? That will be quite a sum. After all, if windows were never broken, what would happen to the glass business? Then, of course, the thing is endless. The glazier will have $250 more to spend with other merchants, and these in turn will have $250 more to spend with still other merchants, and so ad infinitum. The smashed window will go on providing money and employment in ever-widening circles. The logical conclusion from all this would be ... that the little hoodlum who threw the brick, far from being a public menace, was a public benefactor.

Now let us take another look. The crowd is at least right in its first conclusion. This little act of vandalism will in the first instance mean more business for some glazier. The glazier will be no more unhappy to learn of the incident than an undertaker to learn of a death. But the shopkeeper will be out $250 that he was planning to spend for a new suit. Because he has had to replace a window, he will have to go without the suit ... Instead of having a window and $250 he now has merely a window. Or, as he was planning to buy the suit that very afternoon, instead of having both a window and a suit he must be content with the window and no suit. If we think of him as a part of the community, the community has lost a new suit that might otherwise have come into being, and is just that much poorer.

The glazier’s gain of business, in short, is merely the tailor’s loss of business. No new “employment” has been added. The people in the crowd were thinking only of two parties to the transaction, the baker and the glazier. They had forgotten the potential third party involved, the tailor. They forgot him precisely because he will not now enter the scene. They will see the new window in the next day or two. They will never see the extra suit, precisely because it will never be made. They see only what is immediately visible to the eye.

The logic of this argument seems almost obvious, yet we see this broken logic applied over and over again. For example, people say the war in Iraq is good for the economy. Or Kartrina was a tragedy but at least it will create jobs to rebuild New Orleans. Even Paul Krugman thought that 9/11 had positive effects for the economy
So the direct economic impact of the attacks will probably not be that bad. And there will, potentially, be two favorable effects.

First, the driving force behind the economic slowdown has been a plunge in business investment. Now, all of a sudden, we need some new office buildings. As I've already indicated, the destruction isn't big compared with the economy, but rebuilding will generate at least some increase in business spending.

Second, the attack opens the door to some sensible recession-fighting measures ... Now it seems that we will indeed get a quick burst of public spending, however tragic the reasons.

In the first six chapters, Hazlitt has applied this logic to many different examples including public work projects and government loan guarantees. This book was written in 1946 and last updated in 1979. This paragraph almost seems to be written yesterday:
The advocates of government-guaranteed mortgages also forget than what is being lent is ultimately real capital, which is limited in supply, and that they are helping identified B at the expense of some unidentified A. Government-guaranteed home mortgages, especially when a negligible down payment or no down payment whatever is required, inevitably mean more bad loans than otherwise. they force the general taxpayer to subsidize the bad risks and defray the losses. They encourage people to "buy" houses that they cannot really afford. They tend eventually to bring about an oversupply of houses as compared with other things. They temporarily overstimulate building, raise the cost of building for everybody (including the buyers of the homes with the guaranteed mortgages), and may mislead building industry into an eventually costly overexpansion. In brief, in the long run they do not increase overall national production but encourage malinvestment.

Now some may argue that the subprime problem wasn't caused by government guaranteed loans, but it's only a small step to see how government effectively distorts the market and created the environment in which the current problems came into being. I don't want to turn this into a post on the housing market, but I'll briefly list a few government policies that are at fault:
  • Extended periods of below market interest rates,
  • Subsidies through the tax code on owning a house versus renting,
  • Government-guaranteed loans by FreddieMac, FannieMae, and the FHA,
  • The Federal Reserve Chairman encouraging "innovative" mortgage products,
  • SEC regulation of the credit rating agencies that resulted in the debt seller purchasing the ratings instead of the debt buyer,
  • Previous government bailouts (1980's S&L, dotcom bubble, Long Term Capital Management) that created the moral hazard of expected future government bailouts. Also known as the Greenspan Put. Also known as the Bernanke Put.
And now among the proposed solutions in the recent stimulus package is increasing the number and size of government-guaranteed loans. Oh, we'll never learn.

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