Economic Literacy in One Mighty Lesson
Rewiew by Wolfgang Kasper
Click here for PDF version

Basic Economics: A Citizen's Guide to the Economy
by Thomas Sowell
Basic Books,2000,US$30.00, 366pp,ISBN 0 465 08138 X

One of the criteria for predicting a communityÕs future prosperity is its Ôeconomic literacyÕ. Citizens and leaders are economically literate if they understand thatÑin a complex evolving economyÑeverything depends on everything else: that business transactions and political coordination are costly pursuits, that mere push-button interventions often backfire, and that ballot democracy must therefore not be allowed to subvert the dollar democracy of the marketplace. Economically literate citizens tend to reject the populist junk science peddled by self-seeking interest groups and the media.1

If there is a single recent book that can advance economic literacy in this country, it is Tom SowellÕs latest book, Basic Economics: A CitizenÕs Guide to the Economy. He is an old friend of The Centre for Independent Studies (CIS), known to many supporters of CIS since he gave the 1988 Bonython Lecture.2

Basic Economics is founded on the insight that Ôthe basic principles . . . are not terribly complicated, nor the facts particularly obscure. What gets complicated is disentangling a fairly straightforward story from a jungle of preconceptions and emotion-laden mythsÕ (169). The book has no graphs and no inaccessible terminology, but tons of sound commonsense. It makes economics accessible to the laymanÑnot by dumbing economics down and ignoring the interdependencies of economic life, but by presenting time-tested knowledge in imaginative plain English and through numerous telling examples. In many respects, it is a worthy successor of the perpetual bestseller, Henry HazlittÕs Economics in One Lesson, first published in 1946 and still going strong. In virtually all respects, it surpasses HazlittÕs classic in clarity, coverage and relevance.

Coverage and contents

The book starts with the role of prices as a superior signalling mechanism not only for coordinating producers and buyers of given resources, but also for discovering new wants and new resources. Markets of course value different peopleÕs contributions differently, even unfairly, but Ôunfairness to particular individuals is what makes the economy as a whole operate more efficiently for the benefit of vastly larger numbers of othersÕ (20). Economics is, after all, about the material wellbeing of the community, not the comfort or security of particular individuals.

Part II deals with the evolution of industry and commerce, the dynamics of markets in which profits and losses are the driving forces and where political action can easily become a costly disturbance. ÔNo economic system can depend on the continuing wisdom of its existing leaders. A price-coordinated economy with competition . . . does not have to, because those leaders can be forced to change courseÑor be replacedÑwhether because of red ink, irate stockholders, outside investors ready to take over, or because of a bankruptcy court . . . it is hardly surprising that economies under the thumbs of kings or commissars have seldom matched the track record of capitalist economiesÕ (67).

When discussing profits, in Marxist eyes an unnecessary surcharge, Sowell writes: Ô. . . profit is less costly than inefficiency . . . profit is a price paid for efficiencyÕ (75). Or later, when discussing how governments shore up monopolies, he remarks: Ô . . . just as dams can prevent water from finding its own level, so government intervention can prevent a monopolyÕs profit rate from being reduced by competitionÕ (91). Such phrases show the mastery of a seasoned old trooper who has tempered his arguments on many a battleground.

Part III deals with work and pay. He demonstrates the deleterious consequences of minimum wages and decreed workplace security, most notably in unemployment. He addresses popular confusion about income distribution: ÔMost income is distributed only in the statistical sense in which there is a distribution of heights in a populationÑsome people being 5 foot 4 inches tall, others 6 foot 2 inches, etc.Ñbut none of their heights were sent out from some central location. Yet it is all too common to read journalists and others discussing how ÒsocietyÓ distributes its incomeÕ (134). On a few masterful pages, Sowell deflates much fuzzy thinking about labour, for example when he writes that Ô[a]ttempts to make prices, including the prices of peopleÕs labor and talents, be something other than signals to guide resources to their most valued uses, make those prices less effective for their basic purpose, on which the prosperity of the whole society dependsÕ (137).

In the following section, Sowell deals with time and risk, discussing investment and saving, economic speculation, inventories (characterised as Ôsubstitutes for knowledgeÕ), rates of return, present value, calculable risks and incalculable uncertainties, insurance, and social ÔsecurityÕ. He shows how competitive private solutions to dealing with the consequences of time and ignorance often produce better results than collective choices, but acknowledges a Ôpolitically irresistible inclinationÕ to meddle and regulate. I particularly liked the characterisation of speculation as Ôthe opposite of gambling. What gambling involves . . . is creating a risk that would otherwise not exist . . . What economic speculation involves is coping with an inherent risk . . . to minimize it and to leave it to be borne by whoever is best equipped to bear itÕ (179).

The Part on the national economy treats macroeconomics, where we Ôencounter a great deal of confusion spread by politicians and media commentatorsÕ (217). He explains how real output is measured, the role of money, inflation and cyclical fluctuations (along Chicago monetarist lines), and the financial system. All this is done with the crisp brevity which macroeconomics deserves. He then turns to government, whose key role is to protect law and order, including safeguarding property rights, so that people can confidently explore and exploit knowledge. Laws must be reliable, dependable and impartial, but government-made law can do no more than back up the social order. I would have made more of the internal institutions that constitute social orderÑthe evolved rules and attitudes reflected in time-tested customs, morals and work practices that society enforces spontaneously and cheaply. After all, legislation inflicts high monitoring and enforcement costs and relies on coercion rather than more or less voluntary compliance with the internal norms of well-functioning civil societies.

Sowell shows that private property rights are essential to coordination in markets. Profits and losses only motivate people when they augment or diminish peopleÕs property. The market system is made dysfunctional by interference with private property rights, for example by regulations or subsidies to compensate corporations for losses, as seems to have become the fashion under the Howard government. Sowell also highlights the role of property rights in encouraging wise stewardship of natural resources: ÔThe only animals threatened with extinction are animals not owned by anyone. Colonel Sanders is not about to let chickens become extinctÕ (243). He also deals briefly with cases where market decisions cannot reflect the true costs and benefits (externalities) and where costs or benefits are indivisible (for example, military defence or standard measures). This justifies recourse to public choice, but Sowell warns that public choice is no guarantee of better outcomes, given the propensity of government agents to act in self-seeking ways and forget the public interest.

Part VI deals with the international economy, but not, as in older American textbooks, as a mere add-on. In the more open economies of the 21st century, international competition and international transfers of capital, knowledge and enterprise are integral parts of everything, so that one has to consider foreigners as a natural component of the supply and demand in most national markets. Sowell treats international economic relations in that spirit.

The seasoned, experienced teacher is at his very best when discussing some common fallacies. He tackles head-on those postmodern critics of economics, who belittle economics as dealing with mere material values, while they, the critics, pursue higher and nobler concerns: ÔEconomics is not a value in and of itself. It is only a way of weighing one value against anotherÕ (305). The need to evaluate conflicting demands on scarce resources is of course inescapable, though contemporary neo-romantics try to ignore this when attacking Ôeconomic rationalismÕ. Such attempted escapism from scarcity is as dangerous for policy as the denial of gravity for aeronauts. Sowell points out that people who attack ÔgreedÕ are themselves often political operators driven by greed for power.

Among populist misconceptions, Sowell also picks up on the fallacy that the same price should be charged for the same product irrespective of locationÑthink of AustraliaÕs populist rural socialists who demand petrol outback at city prices, but who would never pay Sydney prices for farm land! And he deals with the Keynesian fallacy that government can and should inflate demand when private demand flags.

In this final chapter, Sowell offers us another hint why economics is not all that popular, including among businessmen. Few have a natural inclination to compete, time and again, by risking innovations or cutting costs. Competition may be a tremendous boon to the wealth of nations, but it is most uncomfortable to people with property and talent who are challenged to risk their assets, again and again, if they wish to maintain their wealth.

A few quibbles

Nobody is perfect. And so is no book, although this introduction comes close to the mark. Nonetheless here are a few quibbles.

The book begins with Lionel RobbinsÕ famous definition of economics as Ôthe study of the use of scarce resources which have alternative usesÕ (1). This reflects an older, static view of economics. Fortunately, Sowell treats the economy as a dynamic phenomenon. Why not give the definition of economics a timely, explicit dynamic twist by stating that economics deals with scarcity, which is the natural consequence of peopleÕs ability to discover more wants than resources to satisfy them? Basic Economics is imbued with the spirit of Austrian economics like no other introductory text I know. Therefore, I would also have welcomed a mention of the names of the great Austrian economists of the past centuryÑLudwig von Mises, Friedrich Hayek, Joseph SchumpeterÑat least in the Appendix, where pointers are given to further reading for those whose appetites have been whetted.

On a methodological level, I would have found it useful to treat transaction costs explicitly. After all, over half of all costs incurred in a modern economy with a deep division of labour are transaction costs.3 They are rising fast as the rapid growth of finance, trade, business and legal services demonstrates. What makes this book so appealing is that Sowell acknowledges the costs of doing business and regulating commerce in his real-life examples. A more explicit treatment of the costs of transacting business and innovating would have explained more clearly how institutions can reduce these costs, facilitating specialisation and innovation, hence economic growth. The message is of course there. But making this central aspect explicit would have differentiated the book more clearly from neoclassical textbooks and would have made it even more attractive to practical people. Policymakers would find it harder to forget about the transaction costs. After all, the litmus test for whether someoneÑwhether in academia, the media, or politicsÑcan be considered economically literate is whether he recognises transaction costs and makes judgments accordingly.

Sowell as an antidote to the crisis of Australian economics

One can only appreciate the importance of this book if one sees it in the context of Australian economics being in a crisis. Enrolments in Australian economics courses at high school and tertiary levels have fallen dramatically, reflecting overseas trends. The economics profession has lost authority and no longer dominates government policymaking.4 Economic literacy seems in decline in public discourse and policymaking.

The reasons for this are easy to see. The discipline has become increasingly abstract and sterile. The dominant paradigmÑneoclassical economicsÑis based on wholly unrealistic assumptions, such as Ôperfect knowledgeÕ about all ends and all means, and perfectly honest agents. Confining economic analysis to narrow end-means rationality seems to me the ultimate reason why the Business Economists split from the academic, theoretical Economic Society and why lawyers, managers, traders and others who deal daily with the transaction costs of imperfect knowledge have given up on formal economics.

CIS publications have repeatedly criticised the abstract, formalistic, anodyne and static economics taught and researched in our universities, as well as the weird model assumptions that so often devalue policy advice by economists.5 Different from overseas, such criticism is still rare in Australia. It is not welcome either because it is an invitation to write off much outdated human capital.

As Sowell demonstrates, the ends are being explored all the time and the means are often unknown in real business life and policymaking. The modern, dynamic knowledge economy requires bounded and entrepreneurial rationality, which are not irrational modes of behaviour. Yet ignorance and anything other than narrow end-means rationality have been Ôassumed awayÕ to allow the construction of elegant models.

Neoclassical economics therefore has nothing or little to say about such important phenomena as innovation and learning, the real causes of economic growth, rent-seeking and agent opportunism, privatisation, regulatory reform and transaction costs. Even key Australian policy organisationsÑTreasury, the Reserve Bank and the Productivity Commission who give the right adviceÑhave shied away from jettisoning unrealistic models and from fully exploring the logical consequences of a more open, evolutionary economic paradigm. Often, the supporting analytical material that they publish remains stuck in the narrow reasoning of neoclassical models. Dynamic phenomena, such as economic growth and regulatory reform, cannot be properly analysed within comparative-static models.

Postmodernist romantics therefore found it easy to give Ôeconomic rationalismÕ a bad name. In popular Australian debate, the term is used to reject the unwelcome reality that scarcity dominates our livesÑin other words, to reject economics per se. When Ôeconomic rationalismÕ is defined as neoclassical maximisation, I find myself opposed to it. When the term is used to cover all sorts of rational behaviour to cope with limited knowledge and scarce resources, I have to declare myself an Ôeconomic rationalistÕ. For practical purposes, the term is probably best avoided.

Doubts about neoclassical economics probably became widespread in the 1970s, when the Keynesian recipeÑcombating rising unemployment with loose monetary and fiscal policiesÑwas tried, including in WhitlamÕs Australia. It produced only stagflation and obdurately high unemployment. The supply-side economics, which dominated economic policy advice in the 1980s and 1990s with its proposals for regulatory reform and privatisation, owed little to neoclassical economics. It owed almost everything to Austrian economics and insights from economic history, the analysis of economic systems, business management, the law, and economic psychology.

If economics is to flourish again, it will have to rejuvenate itself by integrating institutional-evolutionary assumptions into the mainstream, in particular more realistic assumptions about individual motivation and values and an Austrian understanding of how dispersed, evolving knowledge is tested and utilised. Invisible to the hasty reader, SowellÕs book contains a very sophisticated view about knowledge and decisionmaking.6 This makes it a thoroughly modern introduction to economics, which prepares the reader to think about dynamic change and the growing services sector.

Australian academic teachers could make an excellent start on the rejuvenation of their discipline by using SowellÕs book in a non-technical introduction. This would certainly raise student enthusiasm and instil a good basic understanding, before abstract assumptions and formalism take over. Nor do I know of a better book on which to base introductory economics courses for engineers, lawyers, business schools, or those other disciplines that used to stipulate a coverage of fundamental economics, but are now doing so less and less.

The book seems timely also for another reason. It is a wonderful antidote to the mechanistic lecturing by the ÔPowerBook generationÕ. Students are often overwhelmed by a rapid-fire kaleidoscope of graphs, as if these presented any ÔevidenceÕ.7 What needs to be taught first is a genuine, critical capacity and the skill to assimilate bits of information into a coherent body of knowledge. Otherwise, the information revolution will overwhelm us with information overload, and IT would then stand in the way of the knowledge society.

Those colleagues who are seriously worried about the decline of economics might, in their introductory courses, teach more about fundamental valuesÑ especially freedom, social order, private property, competition, transaction, coordination and agency costs, unintended consequences and rent-seeking. This is not as easy as showing abstract, simple models. But Tom Sowell shows how it can be done. Seen in this light, the availability of Basic Economics is a stroke of good fortune for us.

An antidote to junk economics

A separate concern is the rise of populist attacks on every sort of economic analysis based on Ôjunk scienceÕ. In the social sciences, the media and on the internet, much currency is nowadays given to hypotheses about how the economy works; these have not been tested by experts in the discipline against accepted, time-tested knowledge, using proven techniques of critical inquiry. A flood of neo-romantic Ôjunk economicsÕ is fed directly to a credulous public and ignorant denizens of the media who prefer the moral melodrama of blame and claim to a rational understanding of the interdependencies. As a result, the critical quality of economic literacy will decline if economists fail to connect with reality again.

The answer is not to follow authors such as Hugh Stretton, Peter Brain and Frank Stilwell, let alone the gaggle of postmodernist Australian sociologists. Their agitation against privatisation, free trade, foreign investment and institutional reforms is no more than an advocacy of na•ve collectivist solutions. The last thing that Australian economics now needs is an injection of warmed-up Marxist collectivism. Human nature cannot be changed by social engineering, and economists must work on that basis. They have no alternative but to turn to the Austrian-evolutionary- institutional approach that Sowell represents. Basic Economics equips the student and the citizen to evaluate the flood of junk economics that is constantly force-fed to us.

Alas, neoclassical economics offers little defence against the new junk economics. Nor can we always rely on great economists, who are given to abstract analysis devoid of fundamental values and commonsense and who have on occasions sounded outright foolish. One notorious example was John Maynard KeynesÕ Foreword to the first German translation of his General Theory. In 1937, he wrote that Germany under the National Socialist German WorkersÕ Party (i.e. HitlerÕs totalitarian party) was best suited to implement Keynesian economics! AnotherÑand one that epitomises the bankruptcy of neoclassical economicsÑ was the assertion by Nobel Prize winner Paul Samuelson in the 1989 edition of his bestselling textbook: ÔThe Soviet economy is proof that, contrary to what many sceptics had earlier believed, a socialist command economy can function and even thriveÕ (837). Readers of the Sowell book will be well equipped to immediately doubt such pronouncements, as they will be aware of fundamentals about human nature, human ignorance and the values that define the good society.

Conclusion

Basic Economics is firmly grounded on a thorough understanding of individual cognition and material incentives. Neither does the book shy away from normative economics, which distinguishes it most laudably from most available introductions to economics. It points out what is good or bad in promoting prosperity, justice, harmony, security and liberty, and what interventions detract from these fundamental values. Tom Sowell has managed to make economics humane again, relevant and interesting to young people and ordinary citizens. His economics remains anchored to his mission to serve as a citizenÕs guide to economic life.

My recommendation is: Buy a copy and read it immediatelyÑno: buy two, and give one to a school teacher, a journalist or a politician near you!

Endnotes

1 Those many internationally experienced business people who contributed to recent surveys of international competitiveness by the Lausanne Business School IMD tend to rate Australia a mediocre 10-15th on Ôeconomic literacyÕ out of forty-odd countries. Japan, Singapore and Hong Kong tend to come first; South Africa, Russia and Latin countries last.

2 T. Sowell, Endangered Freedom, Fifth Bonython Lecture (Sydney: The Centre for Independent Studies, 1988).

3 D. North, Transaction Costs, Institutions and Economic Performance (International Center for Economic Growth, 1992).

4 W. Coleman and A. Hagger, Exasperating Calculators: The Rage over Economic Rationalism and the Campaign against Australian Economists (Sydney: Macleay Press, 2001).

5 W. Kasper, Property Rights and Competition (Sydney: The Centre for Independent Studies, 1999); D. B. Klein, ÔWhat Do Academic Economists Contribute?Õ, Policy 16: 2 (Winter 2000), 30-2.

6 This implicit quality of the book is based on serious conceptual work done earlier on the importance of knowledge in economic and social evolution. See T. Sowell, Knowledge and Decisions (New York: Basic Books, 1980).

7 The problem seems particularly acute in the new programmes for distance education. What I have seen lately relies heavily on the mindless use of simplistic graphs and shies away from critical discussion of the assumptions on which such graphs are based.

Wolfgang Kasper is Emeritus Professor (UNSW)and Senior Fellow at The Centre for Independent Studies.

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