Wednesday, October 06, 2010

Economics in one lesson by Henry Hazlitt

This book is just what the title suggests. It is perhaps the single most important lesson in economics for every human being. It is the lesson that most of the time, a government does not create value. Instead, it merely redistributes wealth, and forcibly, through taxes, invariably from the more efficient producers of value to the less efficient ones. Although this lesson may seem obvious if stated in this manner, the author rightly points out that most nations, shockingly, still haven't imbibed Adam Smith's lessons on the benefits of free-trade and capitalism, let alone the ideologies of the 20th century Austrian school of economic thought. It is the single most important lesson of the classical economists. FA Hayek, one of the stalwarts of the classical liberal movement of the 20th century, vouches for this book. He says, "It is a brilliant performance. It says precisely the things which need most saying and says them with a rare courage and integrity. I know of no other modern book from which the intelligent layman can learn so much about the basic truths of economics in so short a time." Its greatest virtue is the simplicity of language and layman friendly explanations, along with illustrative examples even a high school student can grasp. Hayek's Road to Serfdom is the work of a philosopher more than an economist, and it has that vague philosopher's gobbledygooky tone to it. But Hazlitt, who has served as editor on the board's of many big news sources in his time, has that crispness of language which makes the book an easy read. As Hazlitt says in the conclusion, the main aim of the book is to make the reader understand the effects of government interference in markets on the Forgotten Man, in other words, what are the effects of a special interest petition, whether it be parity prices, export subsidies, tariffs, or price-fixing, on the parties not making the petition. Each individual plays the role of consumer, producer, and taxpayer in an economy, and all too often we compartmentalise ourselves into these modes, without considering the three interrelate. He also stresses the importance of understanding the long run consequences of economic policy, without exultation at the short term result of a distortion in markets. It explains clearly the functioning of free-markets, the role of supply and demand in setting the price level, and the effect of arbitrary perturbations on the market equilibrium either through government interference or popular coercion. He elaborates on how supply and demand are two sides of the same coin. The one cannot arbitrarily exceed the other for any sustained period of time. The author states it beautifully as 'There is no limit to the amount of work to be done. Work creates work. What A produces constitutes the demand for what B produces.' Let us take a simple example of this kind of perturbation on the free market: Minimum wage laws and union rates. As the author says, in an exchange economy everybody's income is somebody else's cost. Every increase in hourly wages, unless or until compensated by an equal increase in hourly productivity, is an increase in costs of production. This in turn would reflect in a change in the price level, or what we call the consumer price index, thus ultimately making nobody making nobody wealthier in the best case, but in a more realistic scenario it only increases unemployment. The elasticity of demand for labour is between -3 and -4 in most low-skilled wages and mimimum wage laws are the surest way to increase unemployment. So in stead of allowing a man to earn a mimimum wage and support his family, you put him on the streets, and then give him unemployment benefits through taxing the same producer, but giving him nothing in return, whereas he would've got some returns in stead if he could hire the worker on a minimum wage. It is important to understand that wages are merely labour prices. Just as price levels must be determined by supply and demand, so must wage levels. To take another example, fixing prices above the market level (as is still being demanded in India today. See this and this.) would either reduce demand (depending upon the elasticity) and thus lead to wastage of produce or operation of production at non-optimal efficiency, or if the demand for the price-fixed product is inelastic (as with rice in the hyperlinks above), it would lead to reduced demand elsewhere, throwing other producers out of jobs or reducing profits. Similarly, fixing prices below the market equilibrium would lead to a falling off of profits. And profits are nothing but the capital necessary to meet demand requirements. So reduced profits would scale down production, and possibly create unemployment along the way. Therefore, as the author concludes, any attempt to force prices either above or below their equilibrium levels (which are the levels toward which a free market constantly tends to bring them) will act to reduce the volume of employment and production below what it would otherwise have been. He also highlights a more important role of profits. Not only are profits the necessary capital to meet demand, they are the filter that determines what is demanded and what is not in a free economy. That is, the prospect of profits decides what articles will be made, and in what quantities - and what articles will not be made at all. If there is no profit in making an article, it is a sign that the labor and capital devoted to its production are misdirected: the values of the resources that must be used up in making the article is greater than the value of the article itself. I think this is what Randall Munroe tried to illustrate in this comic. He started the book with a good example on the silliness of the notion of a subsidy which is often demand by the 'dying industry'. He says imagine what would've happened if in the early 20th century they decided to tax the car industry and subsidize the horse-driven carriages in order to save the dying carriage industry. Although this example may seem funny on hindsight, this is precisely what is being done in all nations today as governments subsidize one powerful vote bank industry or the other, distorting the markets and hampering industrial progress. Before the close of the book, he tackles perhaps the biggest devil of 'em all - inflation! He says, 'Inflation is the opium of the people', and there is really no better way to put it. (For instance, how much is India's real GDP growth, minus the staggering 9% overall inflation? Is it a negative -0.5% in the recent 8.5% GDP growth period? Or have they accounted for it when reporting on news sites? There is bound to be inflation in any developing economy, but I wonder how much the growth numbers are fudged by inflation?) This is all of course done to create the money illusion.

The author does not tackle the effects of elasticities of demand and the classical economic theories that take it into account. I'd be interested in understanding the perturbations in classical theory created by demand elasticity so if any of you can suggest good books on the same, please do so in the comments. Thanks.

Finally, as I have stated several times already, this is an excellent introduction to the classical view of economics, and not the only and absolute view. There is a whole other school of economic thought, the Keynesian school, and there are several tomes on how fiscal policy might step in to positively aid free-markets(For instance). As I am only beginning to take a serious interest in economics, I have no opinion on which is the right way of approaching the problems in economics, but I do think the classical economists provide a better starting point than the Marxists :)

As I said folks, this is a busy time academically so the next review may only come after a month or so. It'll be more frequent thereafter for the next two months :)

Upcoming review: Either Uncommon Genius by Denise Shekerjian (If I think it is worth reviewing) or 84 Charing Cross Road (which I'll definitely review)

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