Economics in One Lesson: Wars, Governments, Price Controls and the Boom-Bust Cycle

Economics in One Lesson


by Graham Wright(http://managainstthestate.blogspot.com/)

based on the book by Henry Hazlitt

http://managainstthestate.blogspot.com/


Agenda

1. The One Lesson2. The Lesson Applied

– The Broken Window Fallacy– “War is good for the economy”– “Government can create jobs”– “Government can create wealth”

Activity: How the market allocates resources

– “The minimum wage law benefits poor people”– “The boom-bust cycle is a market phenomenon”– “Government can help an economy recover from a recession”


Frederic Bastiat“What is Seen and What is Not Seen”

(1850)

Henry Hazlitt“Economics in One Lesson”

(1946)


The One Lesson• Economics is a subject haunted by fallacies.• Henry Hazlitt estimated that 90% of the fallacies can be avoided by

remembering his One Lesson…

“The art of economics consists in looking not merely at the immediate but at the longer

effects of any act or policy; it consists in tracing the consequences of that policy not

merely for one group but for all groups.”


BROKEN WINDOWS The Broken Window Fallacy


Claim“Broken windows are good for the economy”



The Broken Window Fallacy

• The fallacy here is looking only at the consequences on one group. • The benefits to the glazier and those people the glazier buys from

are seen.• Another group is unseen.• Suppose the baker was planning to buy a new suit. Now he has to

pay for a window, he cannot buy a new suit. Instead of a window and a new suit, the baker now has just a window.

• The tailor loses work, and so do all the people that the tailor would have bought from.

• The benefits to the tailor are simply redistributed to the glazier.• Overall, the community is worse off by precisely one suit, because

that suit will now never come into being.

BROKEN WINDOWS


Claim“Broken windows are good for the economy”

Broken windows are bad for the economy



Claim“War is good for the economy”

“World War Two ended the Depression!”

“The military makes jobs for industry!”

“If we bring the troops home or cut military jobs,

we will have mass unemployment!”

BROKEN WINDOWS War


• War is a lot of broken windows.• The fallacy of this claim is to see the jobs created by wars.• But the jobs that would have been created are unseen, precisely because

they never came into existence.

• What matters is what is being produced.

In war-torn countries, there is often low unemployment. But many people are employed in jobs to repair the damage caused by the war.

They are jobs replacing lost wealth, not jobs creating new wealth.

In war-like nations, many jobs exist purely to serve the war machine. Unseen are the jobs that would have existed but for the war.

And more importantly, the wealth that would have been created by those jobs.

BROKEN WINDOWS War


Claim“War is good for the economy”

War is bad for the economy

BROKEN WINDOWS War


Claim“Government can create jobs”

BROKEN WINDOWS Government Jobs


• Governments cannot “create jobs” because for every job a government creates, it destroys jobs in the market, because government jobs are paid for by taxes.

• The government jobs are seen.

• The effect is to replace a job serving the needs and wants of consumers, with a job serving the goals of politicians.

• Unseen are

The taxpayers

The jobs and wealth that would have come into existence had taxpayers been allowed to spend their money as they wished.



Government can only redistribute jobs



Claim“Government can create wealth”

BROKEN WINDOWS Taxation and Spending


• All government spending requires taxation, whether the tax is taken immediately, deferred to future generations, or takes the form of monetary inflation.

• All taxes are ultimately paid by consumers (under the threat of violence).• Taxes discourage production, by making marginal businesses unviable, and

disincentivising saving and entrepreneurship; destroying wealth.• Taxes divert production from satisfying the needs of the consumer to satisfying the

needs of government; redistributing wealth.• For all government taxation/spending…

THE COSTS OF TAXATION MUST ALWAYS OUTWEIGH THE BENEFITS OF GOVERNMENT SPENDING;THAT WHICH IS UNSEEN MUST BE VALUED MORE THAN THAT WHICH IS SEEN;

THE SUIT MUST BE VALUED MORE THAN THE WINDOW.

…but the wealth that would have been produced had the taxpayers been able to spend their money freely (voluntarily), is unseen.

…the results of the spending are seen…



Government can only redistribute and destroy wealth



Agenda


– Broken windows are bad for the economy– War is bad for the economy– Government can only redistribute and destroy jobs and wealth


– “The minimum wage law benefits poor people”– “The boom-bust cycle is a market phenomenon”– “Government can help an economy recover from a recession”


Activity: How the market allocates resourcesPRICES AND PRODUCTION


Market prices optimally allocate resources

• Prices are formed by supply and demand.– More demand => higher prices.– Less demand => lower prices.– More supply => lower prices.– Less supply => higher prices.

• If prices are set too high or too low, supply and demand are decoupled and there will be either a shortage (price set too low) or a surplus (price set too high).

• On a free market, prices tend towards the price at which the market “clears”: supply meets demand. This market process is driven by entrepreneurs and investors seeking profits.

• The market process is the structure of production changing to a more optimal allocation of resources for satisfying ever-changing consumer desires.

• A price control is where government intervenes into a voluntary exchange between individuals to force either a maximum price or a minimum price.

PRICES AND PRODUCTION


The market process is entrepreneurs and investors responding to profit and loss signals.

Demand >

Supply

Prices Increase

Profits Increase

Production Increases

Entrepreneurs increase prices to try to maximise profits

Existing firms increase production of that product, and new firms enter the market.

More production needed


The structure of production is rearranged to increase production


When hampered by maximum price controls, the structure of production fails to increase supply; a perpetual shortage.

Demand >

Supply

Prices Capped

No change in Profits

No Change to Structure of Production!

In response to consumer lobbying, government sets a maximum price control. Any sale at a higher price is forbidden.

No profit signal or incentive for existing firms to increase production or for new firms to enter the market.


More production needed

The structure of production does not change; a perpetual shortage


Maximum Price Controls

Maximum price controls create shortages



The market process is entrepreneurs and investors responding to profit and loss signals.

Supply >

Demand

Prices Decrease

Profits Decrease

Production Decreases

Less production needed; resources are needed elsewhere


The structure of production is rearranged to decrease production

Existing firms decrease production of that product, and some firms go bankrupt.

Competition impels entrepreneurs to decrease prices to try to maximise profits


When hampered by minimum price controls, the structure of production fails to decrease supply; a perpetual surplus.

Supply >

Demand

Prices Collared

No change in Profits

No Change to Structure of Production!

In response to producer lobbying, government sets a minimum price control. Any sale at a lower price is forbidden.

No profit signal or incentive for existing firms to decrease production; no bankruptcies.


The structure of production does not change; a perpetual surplus

Less production needed; resources are needed elsewhere


Minimum Price Controls

Minimum price controls create surpluses



The Minimum Wage Law

Claim“The minimum wage law helps poor people”



• The minimum wage law is a minimum price control on labour.• Therefore the minimum wage law causes a perpetual surplus of labour, i.e. involuntary

unemployment.• The minimum wage law is particularly harmful to low skilled labourers, which is primarily

poor and young people, who struggle to get onto the ‘job ladder’.

To see the effects of minimum wage law more clearly, consider what would happen if it was set not at £5/hr, but £500/hr.• Every employer would have the choice of firing his staff, or agreeing to pay them £500/hr. • It is clear that he will choose the former in almost all cases, since most of his staff are just not that

profitable: he would make a loss if he had to pay them that much.• No one except the most highly skilled would have a job! Productivity would decrease and prices would

increase.

Willing workers are denied jobs; willing firms are denied labour. Consumers have to pay higher prices. The structure of production is inefficient.

Those working minimum wage jobs are seen; those who are unemployed because of the law are unseen. The short-term effects are seen; the long-term effects are unseen.

PRICES AND PRODUCTION The Minimum Wage Law


The minimum wage law particularly harms the poor

PRICES AND PRODUCTION The Minimum Wage Law


Agenda


– Broken windows are bad for the economy– War is bad for the economy– Government can only redistribute and destroy jobs


– The minimum wage law creates perpetual unemployment, particularly harming low skilled labourers

– “The boom-bust cycle is a market phenomenon”– “Government can help an economy recover from a recession”


Claim“The boom-bust cycle is a free market phenomenon”

BOOM-BUST CYCLE The Boom-Bust Cycle


The interest rate is a reflection of time-preferences

• The interest rate is the price of borrowing money.• Like all prices, in a free market, the interest rate is determined by supply and

demand. The supply of money to be loaned (savings) and the demand for loans.

• The free market interest rate is therefore a reflection of the time-preferences of the individuals in society; that is, how highly people value current consumption over saving that will allow them future consumption.

• The market coordinates time with interest.• When a central bank inflates the money supply the interest rate price signal is

distorted. This causes the time-structure of production to become distorted.

BOOM-BUST CYCLE

High time-preferences High interest ratesHigh spending, low saving

Low time-preferences Low interest ratesLow spending, high saving


A distorted interest rate creates a malinvestment boom

• With an interest rate lower than the free market rate due to government manipulation, the amount of savings appears to be higher than it really is.

• It appears as though people are saving for the future, when in fact they want to consume now.

• Entrepreneurs are misled into starting more and different, especially long-term production projects, believing they will be profitable.

• There is an “artificial” boom, especially in capital goods industries: housing, construction, mining, manufacturing, etc. This boom is a result of malinvestments of resources in unsustainable projects.

• While the boom continues, the malinvestments are unseen; they appear to be profitable businesses. The bigger and longer the boom, the more malinvestments take place.

• Resources are scarce, so inevitably, there will be a bust, at which time the malinvestments become apparent through bankruptcies and bursting price bubbles.

BOOM-BUST CYCLE


The Boom-Bust Cycle

The boom-bust cycle is a result of government

BOOM-BUST CYCLE


The Recession

Claim“Government actions can help the economy recover”

BOOM-BUST CYCLE


• The bust is followed by an inevitable recession.• The recession is the market process adjusting the structure of production back to

satisfying consumers’ real time-preferences. • Bankruptcies, defaults and unemployment increase as the malinvestments are

liquidated. This frees up the land, labor and capital to be put to use satisfying real consumer demand.

• Further money creation – attempting to keep interest rates low – may delay the bust, but it will only create even more malinvestments, which will cause a bigger bust in the future.

• Hyperinflation is when the money supply is increased so much (in an attempt to delay a bust) that the value of the money rapidly decreases, until it is almost worthless.

• The market process of the recession-recovery can only be slowed down by government interference, since the market process requires free market prices.

BOOM-BUST CYCLE The recession is the recovery period; the “hangover”

following the binge of the artificial boom


Government actions following the bust of 1929 caused the Great Depression

The Forgotten Depression, 1920-21

•From 1913 to 1920, the newly-founded central bank of the United States increased the money supply by 100%.•This created a large artificial boom,

resulting in an inevitable bust in 1920.•Government Interventions to “Help

The Economy”: Almost none

•The recession was severe, but short. Within 18 months, the economy had recovered.

The Great Depression, 1929-1946

• From 1921 to 1929, the central bank increased the money supply by 63%.

• This created a large artificial boom, resulting in an inevitable bust in 1929.

• Government Interventions to “Help The Economy”:Bailouts

Stimulus packagesDeposit “insurance”

Bank nationalisationsHigh government taxation/spending

Public worksHigh deficits/debts

Price controlsFurther money creation

Mass confiscation of goldThe end of the classical “gold-standard” dollar

• The result was very severe, and long; the Great Depression; the economy did not recover for 17 years.

BOOM-BUST CYCLE


Government actions can only impede recovery

BOOM-BUST CYCLE The Recession


Agenda


– Broken windows are bad for the economy– War is bad for the economy– Government can only redistribute jobs– Government can only redistribute and destroy wealth


– The minimum wage law creates perpetual unemployment, particularly harming low skilled labourers

– The boom-bust cycle is a result of government manipulation of interest rates– Government actions during a recession can only impede recovery


Resources

“Economics in One Lesson” by Henry Hazlitt

http://jim.com/econ/

The Ludwig von Mises Institute,the intellectual home of the Austrian School

mises.org

http://jim.com/econ/

http://www.mises.org/

Economics in One Lesson: Wars, Governments, Price Controls and the Boom-Bust Cycle

Education

Transcript of Economics in One Lesson: Wars, Governments, Price Controls and the Boom-Bust Cycle