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Economics in One Lesson

Henry HazlittEconomics in One Lesson, by Henry Hazlitt, is an introduction to free-market economics. It is a great book that you can use to refute many of the most popular economic fallacies that the MSM promotes on a daily basis.

In his writings, Hazlitt gives credit to many great minds, such as Frederic Bastiat and Ludwig von Mises.

The Lesson

“The Lesson” of Economics in One Lesson is that we must examine the immediate effects, as well as the long-term effects of any act or policy, and we must evaluate the consequences of that policy for all groups (not just one group).

The book applies the lesson to twenty-three different scenarios and demonstrates the false nature of many popular ideas. Here’s a summary of each scenario from the book:

The Broken Window

The broken-window fallacy is probably one of the most prevalent misunderstandings in economics today, and it goes something like this: A vandal breaks a store-front window. The baker must replace the window, providing the glazier with business and income. Some would believe (mistakenly) that the crime has an economic bright side because now money must be spent on a new window. But imagine, the baker wanted to buy a new suit, instead of a new window. The result is a loss to the baker, a gain to the glazier and a loss to the tailor: a net loss to the community as a whole. People forget the tailor because his part in the drama is never seen. This illustration was first made by Frederic Bastiat.

The Blessings of Destruction

This broken-window-fallacy-to-the-extreme was made popular after WWII, with the economic resurgence of Germany and Japan. Their new and more efficient plants were outperforming US factories. Nobody would want to have his own property destroyed either in war or in peace. The same is true for a nation. If the new plants were really a clear net advantage, Americans could easily offset it by immediately destroying their old plants and equipment. But it takes capital to do this. The US supplied its former enemies with the capital at a loss to its own investment, through taxation and currency debasement.

Public Works Mean Taxes

The fallacy that government spending provides a net boost to the economy is actually a combination of fallacies. For the sake of this argument, we’ll postpone the matter of deficit spending and inflation, and assume that the public-works spending will be covered, dollar-for-dollar, by taxes. Suppose the government builds a bridge to nowhere. Two fallacies are at work here:

  • The construction of the bridge creates jobs.
  • After completion of the bridge, the nation is wealthier.

The reality is that the taxes collected for the bridge are money that would have otherwise been spent privately, and this expenditure would have created jobs. For every job the bridge “creates”, one is destroyed in the private sector. We do not see the lost jobs because they are not in one place, like the bridge jobs are. The same logic applies to the enhanced national wealth. The bridge is there, but the unbuilt homes and other goods that would have been paid for by the money that was instead wasted on taxes, are not.

Even Paul Kruman falsely believes that wasting money on an alien defense system could save the economy.

Taxes Discourage Production

When government steals takes from A to give to B, its attention is focused on B. It forgets about A, especially about what goes through the mind of A. Why work so hard when a good part of the earnings is taken away? Why invest in something risky when you lose 100% of what you lose, but get only 70% of what you gain? Capital accumulation and production will decrease. Remember: B is a special interest, and A is everybody.

Credit Diverts Production

Government loans, loan guarantees and subsidies do not create credit; they divert it from the more credit-worthy to the less credit-worthy. A subsidy is a tax on a more successful business (A) to support a less successful business (B). Again, B is a special interest, A is everybody. The process is wasteful, since the loan or subsidy is not made to maximize the return on investment, but to achieve some political goal.

The Curse of Machinery.

Another prominent fallacy is the belief that machines and technology cause unemployment. The Luddite rebellion in the early 19th-century England is a great example, where labor unions succeeded in restricting automation and other labor-saving improvements in many cases. The half-truth of the fallacy is evident here: Jobs are destroyed for particular groups in the short term. But overall, the wealth created by using the labor-saving devices generates far more jobs than are lost directly.

Another example is Arkwright’s cotton-spinning machinery in 1760. The use of it was opposed on the ground that it threatened the livelihood of the workers, and the opposition had to be put down by force. Twenty-seven years later, there were over 40 times as many people working in the industry. What happens when jobs are destroyed by a new machine? The employer uses his savings in one or more of three ways:

  • expanding his operations by buying more machines.
  • investing the extra profits in some other industry.
  • spending the extra profits on his own consumption.

The direct effect of this spending is that as many jobs as were destroyed are created.

The net effect to the economy is wealth creation and even more jobs. The job destruction is only short-term and local. In some cases where this effect is major, special relief measures might be taken, but blocking the progress leads to stagnation and poverty. But if we stay focused on the lesson, we remember that we must examine the long-term effects and all groups.

Spread-the-Work Schemes

Similar to the fear of machines, this is the belief that efficiency destroys jobs, and a less efficiency creates jobs. For example, suppose we reduce the work week to 30 hours, but raise the hourly wage to make the total weekly pay the same as before. It would appear as though new jobs are created, and the previously employed have extra time on their hands. But what is not considered is that:

  • The employer must now raise prices and/or cut profits.
  • The stockholders face a loss of the value of their holdings.
  • The employer’s creditors loans are now much more risky.
  • The employer’s customers must pay more and who therefore will buy less.
  • The government loses revenue from the unseen listed above
  • The costs of production are sharply higher.

The least profitable companies go out of business and the least productive workers will lose their jobs. Demand was already saturated, otherwise we wouldn’t be trying to cure an unemployment problem. The result is greater unemployment than before. But such proposals are continuously advanced in the real world. In fact, these measures are proposed regularly in Europe and are often campaign platforms in elections.

Disbanding Troops and Bureaucrats

Assuming expenditures match revenues, and we postpone the discussion of deficit financing. Demobilization releases money to the taxpayers to provide private jobs. These will be wealth-producing, unlike war. The same goes for surplus government workers.

The Fetish of Full Employment

The economic goal of any nation or individual is to get the greatest results with the least amount effort. Production is the end, while employment merely the means. Yet our elected masters do not present full-production bills in congress but full-employment bills. Everywhere the means is erected into the end, and the end itself is forgotten. We can clarify our thinking if we put our attention where it belongs: on policies that maximize production.

Who’s “Protected” by Tariffs?

Adam Smith said, “In every country, it always is and must be the interest of the great body of the people to buy whatever they want of those who sell it cheapest…The proposition is so very manifest that it seems ridiculous to take any pains to prove it; nor could it ever have been called in question, had not the interested sophistry of merchants and manufacturers confounded the common-sense of mankind.” This is as true today as it was then. The central fallacy of protectionism is the negation of The Lesson: to consider special beneficiaries and short-term effects, and to neglect the general and long-term effects of trade restrictions.

Imagine congress is thinking of cutting or abolishing a tariff on sweaters. A sweater company shows that it would be put out of business and its workers thrown out on the street. Congress relents. The company and its employees continue with their contributions to the American economy. What has been overlooked, and who has been harmed?

  • The American consumer, who might have bought a sweater at a lower price and had money left over to spend on other things.
  • The companies that would have sold to that consumer and their workers.
  • The foreign sweater-makers.
  • The American exporters from whom the foreign sweater-makers or their compatriots would have bought goods and services
  • The governments that would lose revenues from the general slowdown of business.

American labor, capital and land are prevented from what they can do more efficiently to what they do less efficiently. Therefore, productivity is reduced, and also real wages. Productivity and wages might rise in the protected industry, but they fall for the overall economy.

The Drive for Exports

Exceeded only by the chronic dread of imports that affects all nations is a chronic yearning for exports. In the long run, imports and exports must equal each other. When we decide to increase our exports, we are in effect also deciding to increase our imports. A typical example of insanity is the belief that the government should make huge loans to foreign countries for the sake of increasing our exports, regardless of whether or not these loans are likely to be repaid. Bad loans made at home, in private commerce, are just that: bad. If this truth is so simple at home, why do people get confused about it when applied to foreign nations? The reason is that the transaction must then be traced mentally through a few more stages. One group may indeed make gains, while the rest of us take the losses. Here we have simply one more example of the error of looking only at the immediate effect of a policy on some special group, and of not having the patience or intelligence to trace the long-term effects of the policy on everyone.

“Parity” Prices

Special interests can think of the most ingenious reasons why they should be the objects of special consideration. Some of their schemes are so wild that disinterested writers do not trouble to expose them. Practicing Goebbels’ technique of the Big Lie, the special interests forge ahead until they’ve fooled enough congressmen (and constituents). Finally, when people realize that the danger of a scheme’s enactment is real, it’s too late. This general history will do as a history of the idea of “parity” prices for agricultural products.

If there is logic in the idea of parity prices, why not extend it to industry and other areas as well. Investigation shows that this would result in high prices for cars, metals, etc. The refusal to universalize the parity principle is evidence that it is not a public-spirited economic plan but merely a device for subsidizing a special interest. When prices go above parity, nobody talks about forcing them down or turning the windfall over to the Treasury. It is a rule that works only one way. At first glance, we only see the farmers and those who sell to them benefit. But when we apply The Lesson, we realize that all other producers, food consumers and other farm products are indirectly harmed. But shouldn’t we make up to the farmer the harm done him by tariff-caused higher prices of industrial goods? Back again to the Lesson. This joint system of tariffs and parity prices means merely that Farmer A and Industrialist B both profit at the expense of Forgotten Man C.

Saving the X Industry

Our aim here is to follow the main results that must follow from trying to save an industry. We are not concerned with non-economic arguments for intervention. We are only concerned with a single argument: if X is allowed to shrink in size or perish through the forces of free-market competition it will pull down the general economy with it, and that if it is artificially kept alive it will help everybody else. Note that tariffs and parity prices, considered above, are special cases of this. There are two ways in general of “saving X.” One is to restrict entry into an allegedly overcrowded field, and the other is to subsidize.

  • Restricting entry is unnecessary: if there is not enough business to support all the firms in the industry, the free market will cull the industry back to good health. If the former is enacted anyway, it will divert capital away from its most productive use, thereby lowering the general productivity and standard of living.
  • Subsidies are nothing more than a transfer of wealth or income to the X industry. The great advantage of a subsidy, indeed, from the standpoint of the public, is that it makes this fact so clear. That’s why we more commonly see the issues confused by use of tariffs, price-fixing, forced monopolies etc.

A modern example is the recent bailout of auto industries around the world. For decades, the MSM propaganda outlets have been trying to brainwash the world that cars are evil and cause of all pollution on earth. Yet, when profits fell during the 2008 financial crisis, Obama himself said we had to save the auto industry at all cost. We could have saved the horse-and-buggy industry too, but we didn’t. The arguments are the same.

How the Price System Works

The notion that profits are bad is widespread and contemptible, but we need to see why profits are both necessary and good. The price system is a supply-demand feedback loop. The cost of a product doesn’t determine the price directly. It does so indirectly through profit signals. Profit is the means of communication in a complex market economy. Everything is produced at the expense of forgoing something else. The price system maximizes consumer satisfaction, something far too complex to do by government fiat.

“Stabilizing Commodities”

Government attempts to “stabilize” commodity prices, such as farm products, are a con game. The true goal is to hold prices above market level, but this is never admitted. History shows that the free market is an effective price stabilizer. Commodity-futures speculators help even out the market. Claims that farmers are victims of low prices are false—except for storage costs, which can be borne by the farmers themselves or by speculators, a choice made by the market. Speculators through overoptimism actually subsidize farmers a little, a pattern found also in the gold and oil markets and, of course, in conventional gambling. In these cases, when government intervenes, it always does so to raise prices, and always causes overproduction and, down the line, lower prices and big losses to taxpayers. “Stabilizing” guarantees future instability.

Government Price Fixing

Government price fixing is common in wartime and natural disasters, when some items suddenly become scarce. Holding a price below market level has two consequences:

  • demand goes up, reducing supply.
  • supply is further reduced because the low price discourages production.

These two consequences both lead to shortages. When the shortages become obvious, the government then tries to “fix” the problem it created with rationing, cost-control, subsidies, and universal price-fixing, which causes distortion upon distortion. The end result is a command economy, totalitarian throughout. History shows in most cases, black markets develop. In other words, people become criminals in order to keep things going. As respect for law goes down, corruption and inefficiencies thrive.

Rent control is a form of government price-fixing. It does all of the things noted above, plus a few more. Rent control is supposed to be a temporary measure, enacted because of a housing shortage and the short-term inelasticity of housing supply. Even the latter is not true though. Higher rents would encourage people to be frugal in their use of space, accommodating more people in a time of housing shortage. Rent controls provide no such incentive. Rent control usually turns out to be permanent because of political pressure. The worse it gets, the harder it is to undo.

The result is that housing goes unrepaired because the landlord has no money to repair it. Slums spread and whole areas are abandoned. Government then steps in with “public” housing, replacing landlords with taxpayers. Rent control seems to help some people for a while, but actually harms many over a long period of time.

Minimum Wage Laws

Wages are in fact prices. Unfortunately, a separate word was coined for wages. Minimum-wage laws are like the commodity price-fixing described above, with the same result. If an employer is forced to pay someone more than he is worth, that someone will lose his job.

It is argued that the employer need only raise prices. But what they don’t realize is that customers will find other sources, and demand will drop, and unemployment will increase.

“Enough to Buy Back the Product”

A popular Marx-based argument put forth by labor unions is that a depression will ensue if wages are not high enough to “buy back the product.” What is forgotten is that A’s income is B’s cost. An above-market wage leads to a higher price (or a lower profit) that will make others less able to “buy back the product.” Above-market wages are self-defeating in another way: Two independent studies, one of theory, the other of historical fact, show that each 1% rise of wages above market causes more than 3% increase in unemployment.

The national product is neither created nor bought by manufacturing labor alone; it is bought by everyone. The best wages for labor are not the highest wages, but the wages that permit full production, full employment and the largest sustained payrolls.

The Function of Profits

The hatred of the very word “profit” shown by many people today indicates how little understanding there is of the vital function that profits play in our economy and our lives. Profits actually do not bulk large in our total economy. In good and bad times, corporate profits after taxes have averaged less than 6 percent of the national income. Accounting for inflation would reduce this number even more. Also, non-corporate profits, e.g., a barbershop, are probably lower. If there is no profit in making an item, it is a sign that the labor and capital devoted to its production are misdirected. Profits guide and channel the factors of production so as to apportion the relative output of thousands of different commodities in accordance with demand. No bureaucrat can solve this problem on his own. The other function of profits is to put constant pressure on the head of every competitive business to be more efficient. In good times he does this to increase profits; in normal times, to keep ahead of his competitors; in bad times, just to survive. Profits, tell us not only which goods are most economical to make, but also which are the most economical ways to make them. History shows that profits are the best way of doing this.

The Mirage of Inflation

It is important to question why inflation has been constantly resorted to and why it has had popular appeal in spite of leading so many nations down the path to economic disaster.

  • Many people confuse money with wealth. Real wealth consists in what is produced and consumed. But the verbal ambiguity that confuses money with wealth is so powerful that people fall into the trap again and again.
  • A second group, less naive, would have our government print just enough extra money to fill an alleged “deficiency” or “gap.”
  • Those who know that printing money will debase the currency but who are content with that for a variety of reasons: they wish to favor debtors over creditors, or exporters over importers, or they want to “start industry going again.”

This is what inflation really does: The government prints some money to pay bills that it is unwilling to tax for. The direct recipients of that money will benefit most from the inflation. Their suppliers and vendors will benefit next, and people outside that loop will lose out. If the inflation lasts for a while and then stops, the economy will be much the same as before, except for some distortion away from the balance of a free market. However, some will have gained and some will have lost during the transition. If inflation continues indefinitely, the value of the currency will eventually fall to zero. History shows hyperinflation is the final step.

The value of money is what people think it is and their best guess as to what it will be. So inflation turns out to be merely one more example of our The Lesson. Inflation is a form of taxation. It is probably the worst form of taxation, which usually burdens the poor the most. In fact, it is a flat capital levy, without exemptions. Inflation discourages thrift. Inflation encourages squandering and waste of all kinds. It ends invariably in collapse.

The Assault on Saving

The saving policy that is in the best interests of the individual is also in the best interests of the nation. Bastiat’s example of two brothers, the spendthrift and the saver, who begin equal but do not end up that way, is the best way of seeing this. The spendthrift spends until he is worthless. His spending contributes to the national economy, at least to the luxury goods and services industries. The saver’s expenditures and savings also contribute to the national economy; the savings go directly into building the capital base, and the saver’s net worth continues to increase, so that the process can go on indefinitely. Saving is therefore another form of spending. Moreover, money spent on capital formation does the national economy more long-term good than money spent on consumption.

There are many fallacies concerning saving. Saving for hoarding is confused with saving for investment. Hoarding, which can indeed harm the economy, is actually a tiny part of the economy as a whole. Hoarding tends to increase in troubled times in response to the perceived trouble, not as a cause of it. To blame “excessive saving” for a business decline would be like blaming a fall in the price of apples on the people who refuse to pay more for apples. Another fallacy is to blame the saver for unsettling the economy by disappointing producers’ expectations. A certain amount of saving is taken into account in making estimates of future demands. Sudden changes in savings rate might unsettle the economy and thereby do harm, but all sudden changes in either direction of any economic parameter have this effect.

Lowering interest rates to increase the demand for capital have the natural effect (considered “perverse” by the central planners) of lowering its supply. Furthermore, as capital markets adjust to the presence of inflation, the result is sharply higher interest rates, especially long-term rates. There is no limit to the demand for capital. Capital is used to reduce the cost of production and thereby raise profits. Reluctance to invest capital comes from an assessment of high risk, most commonly made as a result of uncertainties brought about by
fluctuations in the kind and degree of government intervention.

Read The Book: Economics in One Lesson

Along with What Has Government Done to Our Money?, this book is required reading for anyone that wants to understand how economics really work.

If you want to read Economics in One Lesson, by Henry Hazlitt, in its entirety, you can buy it online.

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