In this classic introduction to economics, Henry Hazlitt explains and illustrates the single most important lesson in economics: Every economic policy has secondary consequences that often do the opposite of the intended effect of the policy. Policies such as tariffs and minimum wage raises are enacted based on fallacies that overlook these consequences. At the root of these fallacies is a tendency to consider only how economic policies will affect specific groups of people in the short term, while neglecting the long-term effects on other industries and consumers. Failure to consider the long-term, broad effects of policies leads the government to impose policies that sometimes exacerbate the problem they intend to solve. In this summary, we’ll explore the consequences of economic policies and government interventions—including rent control, inflation, and tariffs—that result from short-term, narrowly focused fallacies.
(Shortform note: We’ve grouped the fallacies into categories to clarify themes and make them easier to remember.)
Some of the most prevalent fallacies revolve around taxes. Some tax-funded projects are essential to keep the country running. But when the government uses taxes to fund projects and pay wages that are unnecessary, the consequences outweigh the benefits.
Fallacy: Public works projects and other tax-funded projects create jobs and wealth.
Reality: Public works projects and other tax-funded projects divert resources and manpower that would have otherwise supported jobs in private industries.
While some public works projects create necessary structures like roads and bridges, the government launches others primarily to create jobs—but it fails to see the invisible costs. Government spending is paid through taxes, meaning that public works projects come at the cost of the goods and services that individuals would have bought with the money they paid in taxes. This means less money for the merchants providing those goods and services to put toward wages, and lower wages offset the jobs that are created on the public works project.
Furthermore, high taxes cause businesses to slow or stop expanding, avoid starting new companies, delay upgrades to production facilities, reduce job creation, and limit wage raises. Similarly, high taxes make people reluctant to spend or invest their money, which hurts private industry growth.
Fallacy: Government-paid jobs have no negative impact on private industry.
Reality: When government-paid jobs are no longer needed, continuing to fund them with taxes hurts national productivity and wealth.
Taxpayers fund the salaries of members of the military and civilian government workers, and their work is critical to the country’s well-being, but when their services are no longer essential, they become a drain on national productivity and collective wealth. Every tax dollar that goes to paying government workers is a dollar that taxpayers can’t pay to an industry that produces goods, which contributes to national wealth. Lawmakers should regularly evaluate the necessity of all jobs on government payroll and eliminate those that are not needed.
Many policies use various schemes to save jobs, increase employment, or increase wages. However, the ultimate goal should be to increase production levels, because more output creates larger profits for businesses, enabling them to expand production, hire more workers, and/or raise wages.
Fallacy: Labor-saving technology reduces jobs and, thus, collective wealth.
Reality: Labor-saving technology increases productivity and collective wealth, which often leads to an increase in employment.
For centuries, people have mistakenly blamed labor-saving machinery for eliminating jobs. However, any jobs that would be lost to more efficient equipment are offset by:
Overall, labor-saving machines raise production rates, economic well-being, and standard of living—and an increase in employment generally results from those effects.
Fallacy: Spread-the-work practices lead to higher employment.
Reality: Spread-the-work practices decrease productivity and employment levels.
The fallacy that efficiency kills jobs—and that inefficiency leads to higher employment—leads to labor union practices that spread the work among as many people and over as many hours as possible. These practices include:
Fallacy: Full employment is the goal for national wealth and a high standard of living.
Reality: Full production is the goal for national wealth and a high standard of living.
Many people mistakenly believe full employment is the surest way to increase Americans’ prosperity and the national wealth. However, unless production and profits increase in order to support larger payrolls, simply creating more jobs comes at the expense of other jobs, because the money to pay those new workers has to shift from somewhere else. In reality, the goal should be to achieve maximum production, which raises wealth by creating a need for additional workers and provides more goods and services for everyone.
When the government intervenes in private industry—even in an effort to help—it interferes with the natural equilibrium of supply and demand and creates unintended ripple effects.
Fallacy: Government loans enable individuals and businesses to achieve prosperity that they otherwise couldn’t, which contributes to collective productivity and wealth.
Reality: Government loans divert resources away from the businesses and individuals who could create the most productivity and wealth, to businesses and individuals who would and should be weeded out by private industry standards.
Whereas private lenders have strict standards for selecting loan recipients, the government risks taxpayers’ money giving loans to people who fall short of private lenders’ standards. These borrowers are less likely to have the skills and experience to make enough profits to repay the loans. Additionally, businesses use the loans to buy capital (such as equipment and facilities), which is limited in supply. When the government gives a loan to an inefficient business, the capital it buys becomes unavailable to efficient businesses, which would have used it to be more productive and, thus, make greater contributions to employment and national wealth.
Fallacy: Tariffs (taxes on imported goods) help domestic industries compete in a global market, which prevents employees in those industries from losing their jobs.
Reality: Tariffs shift money, manpower, and productivity away from efficient industries in order to support inefficient industries.
Tariffs are another example of a misguided attempt to support employment that, in reality, has no impact on employment and actually hurts production and wages. If a foreign company makes jeans efficiently enough to sell them for $40, while a domestic manufacturer must charge $50 to cover the cost of production, the government may impose a $10 tariff to raise the price of the foreign jeans to $50 in order to artificially even the playing field for the domestic jean maker. With tariffs, companies that aren’t efficient and productive enough to compete in the global market are able to stay in business. Without tariffs, the resources and manpower that would have gone to those inefficient businesses can be redirected to industries that have high production levels, which increases overall productivity.
Fallacy: Having more exports than imports leads to higher employment, wages, and national wealth.
Reality: The value of exports and imports must be equal.
Many people assume that more exports means more American profits, which means more American wealth—but, in reality, exports merely pay for imports. When a British company imports American goods and pays in British pounds, the American company then has two options:
Alternatively, when the transaction is done with American dollars instead of British pounds, the British importer can only pay if she has access to dollars from a previous export. American exports bring in the money to pay for imports, and imports give other countries the dollars to pay for American exports.
Fallacy: Saving one industry from dying benefits all industries, thereby supporting employment and the creation of wealth.
Reality: Saving one struggling industry prevents other industries from growing.
The government sometimes enacts policies intended to save a struggling industry, an effort based on the fallacy that if one industry dies, those workers will become unemployed and unable to support other industries, which will have a negative ripple effect throughout the economy. However, some industries must shrink and die so that the capital and resources going to the dying industry can be diverted to industries that are growing. The workers who lose their jobs in the dying industry will find work in the growing industries.
Sometimes the government’s efforts to help businesses includes artificially raising or lowering the prices of goods. As with other government interventions, price setting throws off the balance of supply and demand and, thus, creates ill effects.
Fallacy: Parity pricing protects farmers’ profits, which allows them to buy industrial goods, thus contributing to full employment.
Reality: Parity pricing hurts consumers and decreases national wealth.
Through exports and domestic sales, there is a steady demand for agricultural goods—but their prices and profits are not always as stable. Parity pricing establishes a price for farm goods that is equal to the cost of the industrial goods that a farmer must buy to produce those goods.
The fallacy behind parity pricing is that when farmers get higher prices for their goods, they’ll be able to buy more industrial goods, which will support full employment. In reality, the prices of farm goods are often raised by reducing supply in order to increase demand—the government often mandates that farmers produce less, or the government pays the farmers to hold some goods off market to limit the supply that’s available to sell. The bottom line is that a smaller supply of farm goods makes the nation poorer overall—in other words, reducing national wealth—while also raising the price of farm goods for consumers.
While parity pricing applies to agriculture, the government artificially adjusts prices in other industries, as well. Artificially raising prices means that consumers have less money to spend on other goods, which deprives other industries of that money to support wages and production. Additionally, when this policy involves restricting production, it leads to fewer total goods, which equates to less collective wealth.
Fallacy: Artificial price ceilings on goods help consumers by preventing the cost of living from rising.
Reality: Artificial price ceilings create shortages of goods, which cause the government to impose other remedies, which each create additional negative ripple effects.
During wartime and other circumstances when inflation causes prices to balloon, the government attempts to help consumers by putting a ceiling on the price of goods—particularly essential goods, such as food. But the government’s attempt to make essential goods more universally accessible to consumers actually leads to a supply shortage, because the low costs of goods cause people to buy more, and the constrained profits from low prices inhibit companies from making enough to keep up with demand.
Fallacy: Rent control protects tenants from skyrocketing housing prices.
Reality: Rent control hurts tenants by discouraging building maintenance as well as construction of new affordable housing.
Another form of price-fixing is rent control, which is often viewed as a method to support low- and middle-income tenants. However, in the long run, rent control hurts not only low- and middle-income tenants, but also landlords, communities, and cities. Among the consequences, rent control:
Adjusting wages is another form of price setting, since wages are simply the price of labor. Artificially raising wages decreases productivity as well as overall wages.
Fallacy: Minimum wage laws benefit workers.
Reality: Minimum wage laws increase unemployment and decrease productivity.
Raising the minimum wage forces companies to do one of two things:
Outside of government efforts to raise the minimum wage for all workers, trade unions also push to secure higher wages for their members. The companies that hire the union workers are likely to raise the cost of goods in order to cover the wage raises. The price hikes raise the cost of living for everyone—essentially taking more money out of other people’s paychecks—while only those union workers have the increased wages to cover the higher cost of living.
Furthermore, when unions push for fair wages, there is no universal standard for what is considered fair, and unions often demand that workers earn enough to purchase the product they help create. However, that is vague and doesn’t increase productivity in order to support higher wages. Rather than aiming for an ambiguous goal of having workers earn enough to buy back the products they create, wages and prices should be set based on supply and demand.
Despite occasional short-term pains to specific groups (which government interventions often aim to prevent), the economy maintains balance and high productivity levels when it’s governed by supply and demand.
Fallacy: The price system—in which supply and demand dictate prices for goods—serves the desires of greedy businesses rather than the needs of the consumers and the national interest.
Reality: The price system naturally diverts capital and manpower to the industries that produce most efficiently and contribute the most to national wealth.
As discussed, various industries grow and shrink in a perpetual circle of life, naturally diverting capital and manpower to the industries that produce goods efficiently and contribute the most to national wealth and standard of living. Similarly, through the price system, the price of goods naturally fluctuates to reflect supply and demand and to keep finite money and capital flowing to the most productive and efficient industries. In other words, every dollar that consumers spend is a vote for production in that industry.
In an effort to set wages and costs that benefit everyone, the government occasionally proposes limiting companies’ profits to levels it considers reasonable—but profits play a critical role in regulating supply to meet demand, because high demand leads to high profits, which the company can use to expand production. Additionally, profits put pressure on corporate leaders to constantly find more efficient and affordable methods of producing goods, because cutting production costs increases profits more effectively than raising prices.
A few fallacies don’t fit into any broad categories, but they are still critical to understand and are relevant to the modern economy.
Fallacy: Destruction—for instance, storm damage or war—requires repair, which leads to a net economic gain (the broken-window fallacy).
Reality: Destruction diverts money from recreational spending to obligatory spending to repair the damage.
One common fallacy in economics is the broken window fallacy, which says that destruction leads to recovery, that recovery creates a boost to the economy. To illustrate why this is a fallacy, imagine that someone throws a brick through a bakery window, and the bakery owner has to pay $250 to replace the window. As a result, the glass repair person will get $250 that he wouldn’t have otherwise had, and, if he uses it to buy a new bike, the bike shop owner will have $250 that he wouldn’t have had. On and on it goes, as the money continues to change hands.
Per the broken-window fallacy, people look at the destruction of the baker’s window and see a net positive effect, as the money cycles through the community. However, this view overlooks the fact that the baker had planned to use that money to buy a new suit. Now, the tailor has $250 less than he would have if the window hadn’t been broken, and the stores where the tailor would have spent that money are losing out on his business, and so on. In reality, the broken window didn’t stimulate any new business—it just shifted how that money was spent.
Fallacy: Inflation puts more money in the hands of consumers, which boosts purchasing power, stimulates the economy, and supports full employment.
Reality: Inflation reduces consumers’ purchasing power by raising the prices of goods and decreasing the value of each dollar.
Inflation is the result of the government taking on a cost that it can’t pay or doesn’t want to pay with tax dollars, so it simply prints more dollar bills. Inflation raises one group’s incomes, which leads to increased demand and higher prices for goods, which raises another group’s incomes, and the cycle continues until the effect has rippled through the economy. Groups whose incomes rise later are forced to manage rising prices before their incomes have caught up. Additionally, since prices rise proportionately to the rise in incomes, collective wealth does not grow.
Fallacy: Saving money doesn’t benefit national productivity and wealth because it’s not being spent directly with businesses.
Reality: Saving money in banks or through investments increases national productivity and wealth.
The belief that saving money deprives the economy of a boost incorrectly assumes that savings sit idly in a vault. In reality, people either save money through investing it or putting it into a savings account, where banks loan it to businesses to invest in buying capital (such as factories and machinery). In either scenario, savings increases the capacity for production, which increases employment and collective wealth.
Three decades after the book was first published,. the author concludes that not only are the harmful policies still being imposed, but they are more deeply embedded into the economic system of the United States and most other countries in the world.
In this classic introduction to economics, Henry Hazlitt explains and illustrates the single most important lesson in economics: Every economic policy has secondary consequences that often do the opposite of the intended effect of the policy. Policies such as tariffs and minimum wage raises are enacted based on fallacies that overlook these consequences.
There are two reasons for these fallacies. First, people commonly focus on how a policy would impact a specific group of people, while neglecting to consider the ripple effect on the rest of the nation. For example, a narrow lens shows that raising the price of bread increases profits for bakers, grain mills, and wheat farmers—but a broader view reveals that the higher prices force consumers to buy less bread. People push economic policies that would benefit them and people like them, despite the possible harm to other groups. Lobbyists and advertising campaigns promote fallacies to minimize the negative consequences and garner public support for these policies.
Second, many people focus on the short-term effects of a policy, while neglecting the long-term consequences, which may not become apparent until months or even decades later. For example, while raising the price of bread initially raises profits for bakers and their suppliers, the higher prices cause a drop in sales that ultimately cuts into those profits. When people fail to consider long-term, indirect consequences, lawmakers end up imposing policies that can hurt the people they intend to help. Instead, well-informed analysis needs to be supplemented with the long-term, big-picture view of how the policy will affect everyone, both directly and indirectly.
(As a caveat, it’s also possible to assess economic policies with too broad a scope. If you focus too much on the long-term, you can overlook short-term damages. Similarly, if you only consider the overall impact on the nation, you may ignore harm to one or a few specific groups. However, most modern economic policies err on the side of being myopic.)
As the title suggests, this book is intended to be straightforward and easily understandable, regardless of your knowledge of economics. Hazlitt doesn’t extensively cite the economists whose theories he promotes or refutes. Rather, his focus is on how the amalgamation of various theories has turned into widely held beliefs and influenced government policies. However, he notes three especially influential economists:
(Shortform note: Hazlitt was a journalist who reported on business and economics. His work appeared in The Wall Street Journal, The New York Times, Newsweek, The Nation, and The American Mercury. His views support libertarian policies, though this book is considered a classic by both libertarians and conservatives.)
In the following chapters, we’ll explore the consequences of economic policies and government interventions—including rent control, inflation, and tariffs—that result from short-term, narrowly focused fallacies. Governments around the world have been fooled by these fallacies. In most cases, they didn’t learn from their mistakes, but repeated them generation after generation. In fact, the original version of this book was published in 1946, and nearly every type of misguided policy mentioned is still relevant today.
(Shortform note: We’ve grouped the fallacies into categories to clarify themes and make them easier to remember.)
Reflect on your experience with economic policies based on fallacies.
Describe an instance when you’ve been positively or negatively affected by a policy that was intended to help a specific group. (For example, the Affordable Care Act intended to improve healthcare for low-income Americans, but it also caused many middle-class Americans to lose coverage and pay higher premiums.)
What role do you think lobbying and marketing played in that policy’s enactment?
Overall, did the policy make things better or worse for the economy as a whole? Why or why not?
How could the policy have been different to create a better solution for everyone?
Some of the most prevalent fallacies revolve around taxes. Some tax-funded projects are essential to keep the country running. But when the government uses taxes to fund projects and pay wages that are unnecessary, the consequences outweigh the benefits.
Fallacy: Public works projects create jobs.
Reality: Public works projects divert resources and manpower that would have otherwise supported jobs in private industries.
People tend to be shortsighted and overly optimistic about public works projects. Many people see the benefits of public works projects—including job creation and construction of useful structures, like roads and bridges—but they fail to see the invisible costs. Government spending is paid through taxes, meaning that public works projects come at the cost of the goods and services that individuals would have spent with the money they paid in taxes.
People generally make two arguments in defense of public works projects, such as building a $100 million bridge:
People overestimate the positive effects of public works projects because they’re visible: You can see the people working on a bridge, you can see the construction progress week after week, and you can drive over the finished bridge. On the other hand, people overlook the costs of public works projects because they’re invisible—you can’t see the jobs and possibilities that were lost because of the taxes, manpower, and other resources that were diverted to the public works project. Additionally, when the primary goal of a project is job creation, the work will inevitably be inefficient, because projects that are unending and inefficient are more successful at creating and maintaining jobs than projects that are finished quickly with a lean crew.
Fallacy: Tax-funded projects create jobs and build wealth.
Reality: Tax-funded projects inhibit private job creation and productivity by taking money out of taxpayers’ hands.
As we discussed regarding public works projects, taxes on individual and corporate earnings take money out of people’s pockets, which inhibits the creation of private jobs and wealth. Of course, some taxes are necessary for basic government services. However, the danger arises when taxes are viewed as a consequence-free source of funding for job-creation and wealth-building efforts.
Taxes create an imbalance between dollars spent and dollars earned. When corporations or individuals earn a dollar, they may only keep 50 cents, with the rest going to taxes. On the other hand, when they spend a dollar, they lose the entire 100 cents. They have to earn significantly more than they lose in order to offset the taxes.
For manufacturing, high taxes prevent companies from expanding, and, if they do expand, they do so with minimal risk. Manufacturers’ reluctance to expand and take on risk slows the adoption of updated, more efficient machinery, which means that the products they sell aren’t as high-quality or affordable as they otherwise could be. Additionally, the high price of doing business deters entrepreneurs from starting new companies. As a result, compared to the potential if companies shouldered lower taxes, taxes inhibit growth among new and old businesses, which leads to:
For individuals, the effects are similar, but on a smaller scale. So much of an employee’s earnings are taxed that it’s difficult for people to accumulate significant amounts of money for investments. Furthermore, when people consider how much of their earnings are taken through taxes, they want to hold on more tightly to the money they have, and they become more reluctant to take risks with it. As a result, people are less inclined to use their money to support private industry growth through spending and investing.
Fallacy: Government-paid jobs have no negative impact on private industry.
Reality: When government-paid jobs are no longer needed, continuing to fund them with taxes hurts national productivity and wealth.
Although taxes reduce taxpayers’ purchasing power, they fund many essential projects, services, and paychecks. Members of the military and civilian government workers—including police, firefighters, and appointed officials—don’t contribute directly to national wealth, but their work is critical to the country’s well-being. However, when their services are no longer essential, they become a drain on national productivity and collective wealth.
During wartime, the government uses taxpayer dollars to pay soldiers for their military service, which is essentially an investment in the country’s freedom and democracy. At the end of a war, people often worry that a mass of soldiers seeking jobs at the same time will lead to high unemployment. However, when the troops are no longer needed, civilians enjoy lower taxes, which means there’s more money in their pockets to spend on goods and services. This spending supports enough job creation that the private industry can eventually absorb the former troops. Additionally, when the former soldiers enter the private workforce, they contribute to the production of goods and services, which adds to the national wealth.
The same is true of other government workers. Although there’s no clear expiration date for an inspector’s or accountant’s job—as the end of a war marks the end of a soldier’s service—policymakers should regularly evaluate whether there are more workers on government payroll than necessary. If a government employee’s service isn’t essential, then it’s solely harming the country’s collective wealth.
Consider the invisible costs of your taxes.
Do you know about how much of your income goes to taxes? If so, how much?
If half of those taxes were eliminated, how would you primarily spend that money?
How much is your local sales tax?
Think of an item you bought recently, such as a shirt or textbook. What was the pre-tax cost of that item? What was the total cost with tax?
If you had no sales tax, do you think you would use that savings to buy more goods? Why or why not?
Many policies use various schemes to save jobs, increase employment, or increase wages. However, the ultimate goal should be to increase production levels, because more output creates larger profits for businesses, enabling them to expand production, hire more workers, and/or raise wages.
Fallacy: Labor-saving technology reduces jobs and, thus, collective wealth.
Reality: Labor-saving technology increases productivity and collective wealth, which often leads to an increase in employment.
For centuries, people have mistakenly blamed labor-saving machinery for eliminating jobs. The relationship between labor-saving equipment and employment seems like a simple equation: If a machine produces the same number of goods with half the manpower, then it eliminates half of the production jobs. However, that doesn’t tell the whole story. As in other policies we’ve discussed, the fallacy overlooks the indirect effects.
Let’s examine how machinery affects employment in the case of a coat company that buys a coat-making machine that requires just half the labor otherwise needed. On one hand, the company could choose to keep all of its employees and simply use the machines to increase production; in this case, there’s no loss in employment, and the company sees an increase in profits. On the other hand, if company leaders fire half of the coat-making employees, there are several ways that the lost jobs can be offset, both within and outside of the company:
There is another layer to this scenario: If other coat companies begin buying machines in order to stay competitive, it will drive down the price of coats, which reduces companies’ profits and employment. In this situation, there are two possibilities:
Overall, labor-saving machines raise production rates, economic well-being, and standard of living—and an increase in employment generally results from those effects. The exception is in developing countries, in which outdated machinery requires an immense amount of manpower to accomplish basic tasks, resulting in full employment.
If labor-saving machinery kills jobs—as the fallacy dictates—then the logical way to maximize employment is to perform all work as inefficiently as possible. That is the approach that labor unions have taken, as they’ve developed make-work rules and featherbedding practices that are designed to protect their members’ jobs.
These practices require a project to hire more workers than necessary, or they limit workers’ efficiency and productivity, thus increasing the number of workers or hours to complete a project. For example, the theater union may require every stage production to hire people who move scenery—even for plays that have no scenery. Or, the painters union may prohibit the use of paint-spraying guns, so that workers have to use a paint brush, which is significantly less efficient.
Fallacy: Spread-the-work practices lead to higher employment.
Reality: Spread-the-work practices decrease productivity and employment levels.
The fallacy that efficiency kills jobs—and that inefficiency leads to higher employment—leads to labor union practices that spread the work among as many people and over as many hours as possible. The fallacy is predicated on the belief that there is only a finite amount of work to be done, and thus it must be shared strategically to maximize employment.
We’ll look at two spread-the-work strategies, subdivision of labor and a shorter work week, and explain how they actually decrease productivity, which hurts employment and national wealth.
One way that unions spread work is by mandating that only members of a particular union perform tasks that are specific to that trade—even if the tasks are minor aspects of another worker’s job. For example, a plumber isn’t allowed to remove tiles herself in order to replace a pipe in the shower. Instead, she must call a tile-setter to remove and subsequently repair the tiles. Although the tile-setter has gained a day of work that she otherwise wouldn’t have had, this spread-the-work practice increases the cost of the work, which harms overall employment.
The spread-the-work requirement forces the homeowner with the broken shower pipe to pay two people instead of one. If the homeowner could have hired only the plumber to do the job, she would have used the extra money to buy a sweater, which means that the wages paid to the tile-setter would have gone to the sweater maker instead. While the equation simply trades one worker’s wages for the other’s, the homeowner loses because she comes out with a fixed shower, when she could have had a fixed shower and a sweater. Both the fixed shower and the sweater represent overall production, which is an aspect of national wealth, meaning that subdividing labor hurts production and national wealth.
Another method unions use to spread work is to promote shorter work weeks, with overtime pay of 150 percent of normal wages. Reducing the standard work week from 40 hours to 30 hours is intended to benefit workers in two ways:
In reality, there are two ways that a shorter work week can play out—and neither increases employment in the long run.
One possibility is that the work week is cut to 30 hours without increasing the hourly wage to compensate for workers’ lost earnings. This practice merely shifts labor hours and payroll costs among more workers, without increasing the company’s output or altering its labor costs, so the company’s production and profits remain the same. As a result, the company has no extra money to create jobs by expanding its own business or support wages in another industry by spending the extra profits elsewhere. Additionally, the workers whose hours were cut from 40 to 30 are taking home smaller paychecks, essentially subsidizing the wages of the new employees.
Another possibility is that the work week is cut to 30 hours with a one-third increase in hourly wages, so that workers are taking home the same pay for less work. This option raises production costs, which puts some companies out of business and decreases supplies of the product. At this point, there are two possibilities:
(Shortform note: In recent years, a number of companies have begun experimenting with 30-hour work weeks, including Amazon, which offers workers the option to work reduced hours at 75 percent of their salaries, with full benefits. A Swedish company called Brath gives workers full pay for 30-hour work weeks, and company leaders insist that shorter days make employees more productive. For more information on this trend, read our summary of the article, “Enjoy The Extra Day Off! More Bosses Give 4-Day Workweek A Try.”)
Fallacy: Full employment is the goal for national wealth and a high standard of living.
Reality: Full production is the goal for national wealth and a high standard of living.
Many people mistakenly push for full employment, thinking that will be the surest way to increase Americans’ prosperity and the national wealth. However, as we’ve illustrated, policies that aim solely to increase employment—including public works projects, labor union make-work practices, and 30-hour work weeks—do not benefit individual or national wealth.
Furthermore, the progress and innovations that have increased America’s wealth have actually reduced employment by eliminating the need for unfit workers, such as children and the elderly. By contrast, countries that have primitive, labor-intensive production methods have full employment out of necessity, but the people and nations are significantly poorer than further-developed countries with lower employment levels.
In reality, the goal should be to achieve maximum production, which raises wealth. Higher output means a greater need for workers and more goods and services for everyone.
Reflect on your experience with labor-saving technology.
Has your company introduced labor-saving technology during your tenure? If so, what was it?
As a result, did your company lay off workers or increase production? Or, was there a different outcome?
In the long term, did the technology help or hurt your company’s overall business?
What effect, if any, did the technology have on the industry as a whole?
When the government intervenes in private industry—even in an effort to help—it interferes with the natural equilibrium of supply and demand and creates unintended ripple effects.
Fallacy: Government loans enable individuals and businesses to achieve prosperity that they otherwise couldn’t, which contributes to collective productivity and wealth.
Reality: Government loans divert resources away from the businesses and individuals who could create the most productivity and wealth, to businesses and individuals who would and should be weeded out by private industry standards.
Similar to the drawbacks of excessive taxes, government loans and credits are problematic when you consider the cost to taxpayers in order to provide those loans. Supporters of government loans argue that the government should make investments that are too risky for private industry—in other words, proponents say that the government should make investments with other people’s (taxpayers’) money that private individuals and institutions won’t risk with their own money. As we’ll see, this leads to wasted capital and lower production.
In order to receive any loan, a borrower must have assets or a reputation for honesty and high productivity, so that the lender can be confident that the loan will be repaid. Private lenders risk their own money, thus they have strict standards for selecting loan recipients. (Banks technically risk other people’s money, but, if a borrower defaults, the bank has to come up with the funds.) By contrast, the government risks taxpayers’ money, thus it gives loans to people who fall short of private lenders’ standards. In effect, this means that the government awards loans to people who are less likely to have the skills and experience to make enough profits to repay the loans.
To illustrate this, we’ll use the example of government loans that enable farmers to buy equipment, livestock, land, or other forms of capital for their business. Proponents argue that these kinds of loans tip the scales for farmers who can’t afford land or equipment on their own. The government money enables a farmer to either launch her business or increase her productivity, both of which help her to earn profits that she can use to repay the loan. As a result, proponents say that the farmer ends up contributing more to the economy than she otherwise would have, which makes the return on the loan greater than the government’s initial investment.
The proponents’ argument would hold up if the loan were from a private lender, but, since the government uses lower standards for lending, the loan actually results in reduced production and collective wealth. The government’s lower standards for lending has two consequences:
For example, Farmer Adam and Farmer Ben are eyeing the same plot of farmland. Farmer Adam has an impressive record of productive, efficient farming and high profits—he’s an ideal candidate for a private loan. Farmer Ben, on the other hand, can’t get a private loan because he has no savings and no record of successful farming.
Since Ben has no other way to get the money he needs to buy the land, government loan advocates favor lending him the money, reasoning that Adam has other options through private loans. In these advocates’ view, giving Ben the opportunity to become a productive farmer is in the community’s best interest. However, when Ben gets the government loan and buys the land, it’s no longer available for Adam. Adam may have other sources of money, but there was just one 100-acre parcel available in the region.
While Ben may succeed and become a high-producing farmer, collectively, the farmers who meet the government’s lower borrowing standards are less efficient and more likely to fail—yet they get capital at the expense of more productive farmers who are denied government credits because they meet private lenders’ higher standards. If there is more land available for Farmer Adam, he could still face higher interest rates or higher land prices as a result of the government’s loans. Either way, the community ends up worse off—not better—because of the obstacles that competent Farmer Adam must face.
(Shortform note: Hazlitt doesn’t account for instances when private lenders give bad loans to risky borrowers, as in the subprime mortgages that led to the economic crash in 2008. Read our summary of The Big Short for more information about financial institutions’ greedy decisions that led to the recession.)
In addition to direct loans, the government also invests in individuals and companies through government-guaranteed loans as well as subsidies. As with government loans, these investments reduce overall productivity and wealth because they fund individuals and businesses who otherwise would—and should—be weeded out in private industry.
(Shortform note: In a government-guaranteed loan, the borrower receives a loan from a private lender, and the government agrees to cover the debt if the borrower defaults. A subsidy to an individual or a company removes financial burdens—due to market failures or other external forces—either directly, via a cash payment, or indirectly, via a tax cut.)
First, we’ll look at the home-building industry as an example of the ripple effects of government-guaranteed loans and mortgages to businesses and individuals. As with government loans, there are similarly low standards for borrowers on government-guaranteed loans. The loans enable people to buy houses that they can’t afford, which falsely signals the building industry to erect more homes, which raises the cost of construction, and that high cost is transferred to homebuyers—including those with government-guaranteed mortgages.
In the case of government subsidies, the funding resuscitates businesses that are in danger of failing. As with any government-funded venture, the money used for the subsidies is funded by taxes from individuals and businesses—and, as we’ve discussed, those taxes reduce taxpayers’ purchasing power to support other businesses. Although there may be circumstances under which subsidies are merited, in general, subsidies support unsuccessful businesses at the expense of successful businesses.
Fallacy: Tariffs help industries compete in a global market, which prevents employees in those industries from losing their jobs.
Reality: Tariffs shift money, manpower, and productivity away from efficient industries in order to support inefficient industries.
Policies that put a thumb on the scales of the market in order to support employment levels—such as public works projects and spread-the-work practices—ultimately hurt production and, consequently, national wealth. Tariffs are another example of a misguided attempt to support employment that, in reality, has no impact on employment and actually hurts production and wages.
With tariffs, companies that aren’t efficient and productive enough to compete in the global market are able to stay in business. Without tariffs, the resources and manpower that would have gone to those inefficient businesses can be redirected to industries that have high production levels, which increases overall productivity. Higher productivity leads to greater national wealth, which raises wages overall. In other words, everyone benefits when people can buy what they want at the best price available, because that structure supports the businesses that are most productive and efficient.
As with everything else, there are certain tariffs that may be necessary, such as those supporting essential wartime industries. Problems arise when the tariffs are imposed primarily to support American employment, wages, or wealth, as we’ll see in the next example.
Let’s look at the impact of tariffs using the example of an American sweater manufacturer. The U.S. company sells sweaters for $30 each, and it’s losing business to a British manufacturer that sells sweaters for just $25. The American company asks the government to impose a $5 tariff, which makes the British sweaters cost $30 for Americans and allows the U.S. company to be competitive. Proponents of the tariff point to all the employees of the American company who will lose their jobs if the business fails. Passing the tariff keeps American sweater workers employed, so that they can earn money to spend, thereby supporting wages in other industries.
However, the British company then has fewer profits to spend on goods, including imports from the U.S. The tariff that helped the American sweater industry hurts other industries, especially those with large export markets. In the sweater example, the tariffs hurt British sweater sales, which means that those manufacturers have less money to import American wool and American-made parts for its machines.
On the other hand, if the tariff is denied, there are several positive ripple effects:
If an existing tariff is repealed, the net effects will be positive, but there is an immediate negative impact on workers and companies within that industry. Many—if not all—of the firms will go out of business, and those employees will be out of work. Employees that have specialized training and skills will suffer an even greater loss, since they’ll be forced to enter another industry at a lower level of expertise and, most likely, pay. This is another danger of imposing tariffs in the first place: Not only do they do harm while they’re in effect, but also if they’re repealed.
Alternatively, consider the impact if the American sweater-making industry doesn’t exist yet, but lobbyists are proposing a tariff on British sweaters so that the U.S. can enter the global sweater market. In this case, when American consumers buy a $30 sweater, they are essentially paying a $5 tax to subsidize the U.S. sweater industry.
At first glance, it appears that the creation of the sweater industry necessarily creates jobs that didn’t exist before. However, the 50,000 workers who get jobs making sweaters are 50,000 workers who are unavailable to work in other industries—and if the American sweater industry didn’t exist, consumers would have $5 extra to spend in other industries to support those 50,000 workers.
Fallacy: Having more exports than imports leads to higher employment, wages, and national wealth.
Reality: The value of exports and imports must be equal.
Besides a misunderstanding of the negative effects of tariffs, there are a number of fallacies surrounding the benefits of exports. Many people assume that more exports mean more American profits, which mean more American wealth—but, in reality, exports merely pay for imports. Imports are of greater value, because they give consumers access to goods that either aren’t available domestically or that are priced better than comparable domestic goods.
When a British company imports American goods and pays in British pounds, the American company then has two options:
Alternatively, when the transaction is done with American dollars instead of British pounds, the British importer can only pay if she has access to dollars from a previous export. American exports bring in the money to pay for imports, and imports give other countries the dollars to pay for American exports.
The misguided value placed on exports has led to practices that are meant to stimulate American exports, but that actually reduce national wealth.
One of these practices is giving foreign countries loans that can fund their import of American goods. Often, the countries are unable to repay the loans. People often believe that the boost to exports more than makes up for the defaulted loans, but, in actuality, the American government has essentially paid for its own exports. Put another way, the country has given its goods away for low or no cost. As an analogy, if a car company loans you $25,000 to buy one of its cars, and you don’t repay the loan, the company suffers a net loss despite the fact that it sold a car.
Another misguided practice is giving export subsidies, which helps foreign countries cover the cost of importing American goods by giving cash payments, loans, or tax cuts for exporters. Again, the boost to exports is an artificial gain, because much of the cost has been covered by the U.S. government. In either case, individual export businesses may gain from loans and subsidies, but the country, as a whole, loses. The government must fund these loans and subsidies with tax dollars, which means that taxpayers have less money to spend. The money taxpayers lose to taxes could have been spent on goods and services, and the industries providing those goods and services could have used those profits to expand production, which would have contributed to national wealth.
Fallacy: Saving one industry from dying benefits all industries, thereby supporting employment and the creation of wealth.
Reality: Saving one struggling industry prevents other industries from growing.
When an industry is struggling, the government may enact policies meant to save it in order to prevent widespread job losses. Campaigns to save struggling industries are based on the fallacy that the health of one industry adds to the health of all industries. Proponents mistakenly think that if one industry dies, those workers will become unemployed and unable to support other industries, which will have a negative ripple effect throughout the economy.
However, the opposite is true: Some industries must shrink and die so that the capital and resources going to the dying industry can be diverted to industries that are growing. The workers who lose their jobs in the dying industry will find work in the growing industries. Furthermore, the prosperous industries grow because they’re productive and efficient, while the dying industry is comparatively less efficient. When the government keeps a dying industry alive, it supports an inefficient industry at the expense of other, more productive and efficient industries. That diversion keeps national productivity and creation of wealth below what it could be if the growing industries were allowed to prosper.
In addition to protective policies we’ve already discussed—such as tariffs and parity pricing—there are two primary practices for saving a dying industry:
1) If the government deems the industry to be overcrowded, it passes legislation to prevent new workers and investors from entering the industry. However, as we’ve discussed, the whole economy prospers when people are free to spend in whichever industries offer the best prices and work in whichever industries offer the best wages. Additionally, through this effort, the government is forcing a process that will happen naturally, as few workers will enter an industry if slowing profits mean low wages, and few investors will inject money into an industry that projects low returns. Doing this artificially limits productivity and national wealth compared to what it could be.
2) If the government decides that the industry needs support via a direct subsidy, it injects tax dollars into the industry. (Shortform example: The Trump administration has used subsidies to prop up America’s dying coal industry.) In this case, taxpayers have less money to spend on more efficient and productive industries because they’ve been taxed in order to save an inefficient industry. Other industries will suffer not only because consumers have less money to buy from them, but also because they may be taxed to fund these subsidies, as well.
Sometimes the government’s efforts to help businesses includes artificially raising or lowering the prices of goods. As with other government interventions, price setting throws off the balance of supply and demand and, thus, creates ill effects.
Fallacy: Parity pricing protects farmers’ profits, which allows them to buy industrial goods, thus contributing to full employment.
Reality: Parity pricing hurts consumers and decreases national wealth.
Through exports and domestic sales, there is a steady demand for agricultural goods—but their prices and profits are not always as stable. During the Great Depression, the price of farm goods plummeted, but the cost of industrial goods and farm equipment decreased only slightly. As a result, farmers couldn’t make enough to buy industrial products, which shrunk the supply of farm goods, and limited supplies raised the cost of groceries. Meanwhile, many consumers had been laid off from their jobs and couldn’t afford higher-priced groceries and other farm products.
Parity pricing was enacted in order to prevent this vicious cycle from repeating in the future. Parity pricing establishes a price for farm goods that is equal to the cost of the industrial goods that a farmer must buy to produce those goods. The principle behind parity pricing is that agriculture is the most basic and necessary industry in a nation, and that its prosperity benefits everyone, thus it must be protected. The fallacy behind parity pricing is that when farmers get higher prices for their goods, they’ll be able to buy more industrial goods, which will support full employment. However, as we’ll discuss next, parity pricing raises the cost of farm goods, so that the industrial workers whose jobs are supported by the farmers’ supplemented income consequently face a higher cost of living.
Parity pricing is yet another example of the government artificially altering the market. This is evident in the government’s various methods for raising the prices for farm goods, such as:
No matter the method, parity pricing has several ill effects. First, two of the methods listed above raise prices by reducing supply in order to increase demand—the government mandates that farmers produce less, or the government pays the farmers to hold some goods off market to limit the supply that’s available to sell. Although the farmer gets more money per bushel (or barrel, or whatever the measurement of a particular crop), a smaller supply of farm goods makes the nation poorer overall—in other words, reducing national wealth. Additionally, although the parity pricing pads farmers’ profits, it also limits their production and sales. This means that farmers sell fewer goods at a higher price, and their income does not increase.
Second, the parity prices that enable farmers to earn an extra dollar per bushel of wheat also mean that bread bakers have to pay an extra dollar per bushel, and the price of bread rises proportionately. This has different effects for two types of supermarket shoppers:
Some people argue that parity pricing helps farmers to compensate for the ways they’re hurt by protective tariffs. Protective tariffs decrease imports for the farm-equipment industry in order to support American-made products—but, when foreign countries export less to the U.S., they also have less money to buy American farm exports.
There are a few problems with the suggestion that parity pricing repairs the damage done by tariffs. First, while the farmer benefits from parity pricing, consumers lose twice because they face higher prices for goods because of tariffs as well as for groceries because of parity pricing.
Second, it’s impossible to protect or subsidize every industry equally. If one industry is protected with a tariff, then another industry that’s negatively impacted needs protection by a subsidy, which creates a ripple effect of other industries that would be positively and negatively affected. There are too many overlapping consequences to put everyone on equal footing. The only solution is to abolish both tariffs and parity pricing.
Fallacy: Government efforts to stabilize commodity prices protect the profits of producers, thus supporting employment and collective wealth.
Reality: Government efforts to stabilize commodity prices reward inefficient producers, create market instability, and reduce overall productivity and wealth.
While parity pricing applies to agriculture, the government artificially adjusts prices in other industries, as well. When the prices of goods drop, people worry that, in the time it takes supply and demand to organically adjust prices, producers will be driven out of business and employees will lose their jobs. These concerns lead to a call for the government to step in and stabilize commodity prices—but, as with parity pricing, this effort brings unintended consequences.
One effort to stabilize prices involves the government either buying crops off the farmers or paying them to keep some of their goods off the market, in order to raise prices by creating an artificial supply shortage. The concern behind this plan is that farmers will put their entire stock of crops on the market all at once—immediately after harvest—and that the surge of supply will make prices plunge and hurt farmers’ profits. However, this strategy has several negative consequences, including:
Sometimes the government simply sets a higher price for goods, without restricting production. This leads to:
Both of these outcomes cause prices to eventually collapse, which creates far more instability in market prices (ironically out of an effort to stabilize prices) than would have resulted from relying on supply and demand.
Proponents of efforts to stabilize commodity prices believe that the speculators who buy large stocks of crops get the profits that farmers should be getting, because the speculators buy from the farmers when the prices are low, and then reap the benefits of higher prices when they resell the crops later. But in reality, the speculators act as a buffer between the farmers and the market. Since the speculators continue to sell the goods throughout the year, they provide a consistent supply to the market, which stabilizes prices for that window of time when farmers sell their goods.
Of course, prices occasionally drop as a natural result of supply and demand, and some producers are naturally driven out of business—but they are the most inefficient producers in an industry. When inefficient producers shut down, it creates space for the most efficient producers to expand, and those producers are able to offer their goods at a lower price. As a result, consumers have access to an adequate supply of goods at a low price, which leaves them more money to spend on other things, thus supporting other industries and increasing national productivity and wealth.
Fallacy: Artificial price ceilings on goods help consumers by preventing the cost of living from rising.
Reality: Artificial price ceilings create shortages of goods, which cause the government to impose other remedies, which each create additional negative ripple effects.
The ill effects of price-fixing aren’t limited to when the government artificially raises prices, but also when it artificially lowers prices. During wartime and other circumstances when inflation causes prices to balloon, the government attempts to help consumers by putting a ceiling on the price of goods—particularly essential goods, such as food. As with other policies that involve the government’s interference with the free market, the intentions may be good, but the consequences are harmful and far-reaching.
When the government keeps prices below what supply and demand would dictate, it produces several outcomes:
As a result, the government’s attempt to make essential goods more universally accessible to consumers actually leads to a supply shortage.
When this effect takes hold, the government may try to regain balance by imposing some combination of the following:
When price ceilings create chronic shortages of a commodity, consumers find substitute goods to meet their needs. As the demand grows for these substitute goods, their prices rise and their supplies drop, which can cause the government to impose price ceilings and rations, creating a ripple effect. This cascade of commodity shortages creates space for budding black markets, which can potentially grow to surpass the legal price-ceiling market. However, producers in the black market tend to produce less efficiently, sell poorer-quality goods, and charge more than established legal producers would under normal circumstances.
Fallacy: Rent control protects tenants from skyrocketing housing prices.
Reality: Rent control hurts tenants by discouraging building maintenance as well as construction of new affordable housing.
Another form of price-fixing is rent control, which is often viewed as a method to support low- and middle-income tenants. However, in the long run, rent control hurts not only low- and middle-income tenants, but also landlords, communities, and cities:
When rent control slows or stops construction of affordable housing, the government may attempt to remedy the problem by building housing with tax dollars, which hurts taxpayers in multiple ways:
The more extreme the rent-controlled price is, the more damage it does, and the harder it is to abolish. In other words, if the policy keeps rents at 50 percent of the market rate, the price cut decreases landlords’ profits and disincentivizes new construction more than a policy that held rents just 5 percent below the market rate. Additionally, if the government tried to get rid of rent control, there’d be greater outcry from tenants whose rents would double than from tenants who would face a much smaller rent increase.
Adjusting wages is another form of price setting, since wages are simply the price of labor. Artificially raising wages decreases productivity as well as overall wages.
Fallacy: Minimum wage laws benefit workers.
Reality: Minimum wage laws increase unemployment and decrease productivity.
Just as artificially raising prices hurts productivity and employment, raising wages has the same effect. Raising the minimum wage forces companies to do one of two things:
Additionally, raising the minimum wage doesn’t raise the value of individual workers. When companies see their profits fall as a result of a minimum wage raise, the workers who are deemed unworthy of the higher wage will become unemployed. Although those workers’ previous wages may have been low, they were presumably the best available—and when the workers lose those jobs, they will be forced to accept work and wages that they had previously considered unacceptable. Furthermore, increased competition further drives down wages for those less-desirable jobs. Overall, minimum wage mandates end up hurting the workers they aim to help.
When minimum wage laws increase unemployment, the government may be tempted to help unemployed workers through relief programs. However, these efforts bring additional consequences.
If the government offers unemployment relief, the payments will likely be less than the workers’ previous wages. If wages were $500 per week before the government raised the minimum wage, and unemployment relief is $400 per week, then the government’s effort to help workers actually pushes many into unemployment and forces them to live off of less income. In the process, consumers also suffer a loss of those workers’ services and contributions to production. (Shortform note: Additionally, research shows that it’s harder to land a job when you’re unemployed, meaning that these workers face a greater challenge in finding a way to earn more than unemployment payments provide.)
Alternatively, if unemployment payments are higher than previous wages—for example, $550 per week—then people are disincentivized from working, which decreases production. Furthermore, if the minimum wage raise lifts paychecks from $500 to $600 per week, workers who are still employed are essentially working to earn $50, since they could make $550 without working.
Instead of unemployment payments, the government may offer work relief programs, which provide unemployed workers with new jobs on government make-work projects. In Chapter 4, we discussed the issues with these job creation projects, such as their inherent inefficiency and the tax burden they place on the public. Additionally, these projects are limited in scope because they must be so simple that they can employ the least-skilled workers—otherwise, if the government were to begin training these workers in more specialized skills, they risk competing with existing industry jobs and upsetting unions.
The problem with raising wages is that the effort tries to distribute wealth that doesn’t exist. In order to truly raise wages, the wealth needs to be created first through increased productivity, which can be achieved through:
Fallacy: When a union achieves wage raises for its members, it sets off a ripple effect that raises wages among all workers.
Reality: When one union achieves wage raises for its members, in the long run, it reduces wages for everyone, including union workers in other industries.
Outside of government efforts to raise the minimum wage for all workers, trade unions also push to secure higher wages for their members. In unions’ early years, they achieved better working conditions and shorter work weeks, which increased productivity by improving workers’ health and well-being. However, in recent decades, union efforts to raise wages for its members provide short-term benefits, but, in the long term, they create unemployment, decrease productivity, and lower wages across the board.
When a union raises one trade’s wages above market rates, it indirectly hurts workers in other industries. The companies that hire the union workers are likely to raise the cost of goods in order to cover the wage raises. The price hikes raise the cost of living for everyone—essentially taking more money out of other people’s paychecks—while only those union workers have the increased wages to cover the higher cost of living.
In the long run, raising wages also creates unemployment among the very workers whose incomes are increasing. If a company is forced to absorb the higher cost of labor, it will either go out of business entirely, or it will have to cut jobs. Alternatively, if a company is able to raise its prices in order to shift the cost burden to consumers, sales are likely to fall, which reduces profits and leads to layoffs. Additionally, investors who support the business face a lower return on their investment when labor costs rise, which disincentivizes them from putting any more money toward the company’s future success. As a result, the company is likely to struggle or close entirely, leading to unemployment.
In order to prevent one union from prospering at the expense of all other workers, some union supporters suggest unionizing all workers. There are two potential outcomes of this proposal:
Fallacy: Wages should be set high enough that workers can buy the products they help create.
Reality: Wages should be set to support the highest level of employment and largest total payrolls possible.
When unions push for fair wages, there is no universal standard for what is considered fair. Classical economists promote functional wages supported by functional prices. In that school of thought, functional wages enable the highest level of employment and largest payrolls possible, and functional prices support the highest levels of production and sales. Still, there is no calculation for determining the most functional wages—and, in its place, unions call for workers to earn enough to purchase the product they help create.
This benchmark calls into question the goal of having each worker make enough to buy back the specific product she creates. If so, there will be a major discrepancy between the wages of workers who make socks and workers who make mink coats. Additionally, workers from many industries contribute to the production of a single product—for example, clothes aren’t made just by the workers who sew them, but also by the workers who mill the cotton, weave the fabric, and assemble the sewing machines.
These questions aside, any wage raise requires producers to find a way to pay for the higher cost of labor, presumably through raising prices on their products. However, as we’ve discussed, unless higher wages are supported by higher productivity, they ultimately lead to unemployment. This result not only hurts workers’ purchasing power, but also lowers the production of goods for everyone to enjoy, which means that the nation is poorer overall.
Rather than aiming for an ambiguous goal of having workers earn enough to buy back the products they create, wages and prices should be set based on supply and demand.
Reflect on your experience with and opinion of minimum wage laws. (Shortform note: Some researchers’ conclusions about the effects of minimum wage contradict Hazlitt’s argument. For example, the Washington Center for Equitable Growth found that raising the minimum wage did not lead to unemployment.)
State and federal elected officials regularly propose new minimum wage laws. In the past, what has been your opinion (or vote, if applicable) on raising the minimum wage?
Has this summary’s explanation of the effects of minimum wage raises affected your opinion? Why or why not?
If you’re in favor of minimum wage raises, what (if any) action do you think the government should take to support workers who lose their jobs as a result?
We’ve seen over and over the ill effects of government intervention in private industry. Despite occasional short-term pains to specific groups (which government interventions often aim to prevent), the economy maintains balance and high productivity levels when it’s governed by supply and demand
Fallacy: The price system—in which supply and demand dictate prices for goods—serves the desires of greedy businesses rather than the needs of the consumers and the national interest.
Reality: The price system naturally diverts capital and manpower to the industries that produce most efficiently and contribute the most to national wealth.
Many people falsely believe that the price system hurts productivity and national wealth because industries only make goods as long as they’re profitable, which:
These opponents of the price system argue that instead of producing only enough laptops to meet demand, manufacturers should produce as many laptops as their factories can put out. In their view, this approach would prevent laptop shortages and price hikes due to limited supply. However, this view overlooks the fact that there is a finite amount of capital and manpower to produce those goods, meaning that all industries can’t produce at full steam at all times.
As an analogy, if a family is stranded on a desert island, they divide the labor in order to survive: The children find firewood, the father finds food, and the mother cooks it. Each family member is an industry producing a type of good. Once the children find enough firewood for the day, it doesn’t help the family if they continue making an ever-growing pile of firewood—their manpower is better spent switching to another task, such as collecting water. Similarly, not only does a nation not need an endless supply of every type of good, but the nation is actually harmed by such an indiscriminate production system, because it creates too much of unneeded goods and not enough of needed goods.
The price system naturally adjusts prices based on supply and demand. The price of goods naturally fluctuates to reflect consumers’ demands, the market’s supplies, and the cost of production. This price system keeps money flowing to the most productive and efficient industries. In other words, every dollar that consumers spend is a vote for production in that industry. Here is a step-by-step example of the effect of supply and demand on pricing:
If profits for laptop production didn’t fall, laptop manufacturers would continue making an endless supply of laptops, which would exceed demand and take resources away from the production of goods that consumers needed more.
Fallacy: Out-of-control profits should be limited for the sake of everyone else’s wealth.
Reality: Profits help regulate supply and demand in order to keep production at optimum levels.
In an effort to set wages and costs that benefit everyone, taxpayers and legislators are inclined to look at the astronomical profits of certain companies and believe that the companies’ executives are greedily hoarding profits while their workers are fighting for a living wage. In response, the government occasionally proposes limiting companies’ profits to levels it considers more reasonable—but those limitations would actually limit productivity, which would hurt employment and overall wealth.
A policy to limit profits is based on a misunderstanding of:
First, the high profits of certain standout companies don’t represent the average profits of most companies. A large portion of companies spend many years operating on losses, and many go out of business within just a few years. A small, elite group of companies actually makes the kinds of off-the-charts profits that spur proposals for imposing ceilings on profits. (Shortform note: In 2016, just 6 percent of companies made 50 percent of corporate profits in the U.S.)
Second, profits play a critical role in regulating supply to meet demand. When a company makes large profits, it’s because demand for its product is high. The profits allow the company to expand its production by buying more equipment and hiring more workers. The profits also attract even more investors to help further production, and this continues until the demand is met. At that point, profits fall again to average or below-average levels.
Additionally, profits put pressure on corporate leaders to constantly find more efficient and affordable methods of producing goods. A company doesn’t increase profits by raising prices, because consumers will simply turn to one of the company’s competitors—the only way a company can get an edge over its competitors is to cut production costs (assuming that the quality is the same among competing companies’ products). As a result, profits reveal and reward the companies that make their goods most efficiently and affordably, and enable those efficient companies to make even more goods, which contributes to national wealth.
Finally, profits motivate investors to support companies, which keeps production and employment healthy. If profits fall, investors are likely to pull back support, which hampers production.
A few fallacies don’t fit into any broad categories, but they are still critical to understand and are relevant to the modern economy.
Fallacy: Destruction—for instance, storm damage or war—requires repair, which leads to a net economic gain (the broken-window fallacy).
Reality: Destruction diverts money from discretionary spending to obligatory spending to repair the damage.
One common fallacy in economics is the broken window fallacy, which says that destruction leads to recovery, that recovery creates a boost to the economy. Like the other fallacies we’ve discussed, this mistaken view results ignores the invisible costs of recovery. To illustrate this, imagine that someone throws a brick through a bakery window, and the bakery owner has to pay $250 to replace the window. As a result, the glass repair person will get $250 that he wouldn’t have otherwise had, and, if he uses it to buy a new bike, the bike shop owner will have $250 that he wouldn’t have had. On and on it goes, as the money continues to change hands.
Per the broken-window fallacy, people look at the destruction of the baker’s window and see a net positive effect, as the money cycles through the community. However, this view overlooks the invisible victims of that destruction. The baker had planned to use that money to buy a new suit. Now, the tailor has $250 less than he would have if the window hadn’t been broken, and the stores where the tailor would have spent that money are losing out on his business, and so on. In reality, the broken window didn’t stimulate any new business—it just shifted how that money was spent.
The tailor’s plight is a secondary consequence. People overlook secondary consequences because they’re not apparent; the destruction of the window makes the tailor’s role invisible to everyone but the baker. The fallacy shows an incomplete picture by focusing on the $250 gained by the window repair person, whereas a complete picture also reveals the $250 lost by the tailor. Ultimately, the destruction causes an equal gain and loss, merely diverting the demand.
Fallacy: Postwar recovery from wartime destruction stimulates the economy.
Reality: Postwar recovery doesn’t create new demand, but rather diverts consumer demand to goods and services needed to repair wartime damages.
The broken-window fallacy is one of the most ubiquitous fallacies in economics, taking on countless forms. For example, after World War II, there was a surge of demand for car manufacturing, home building, and the production of other goods that had been halted during the war. Many people believe that wartime economic damage—via literal destruction of property or damage to industries that lose business during war—leads to a recovery that stimulates the economy.
However, that view fails to distinguish between need and demand:
When people mistake need for demand, they’re failing to see the big picture by confusing a diversion of demand for increased total demand. If you zoom in on one industry or another, you’ll see greater business activity, but you ignore the other groups of people who face only destruction in the wake of the war.
Fallacy: Inflation puts more money in the hands of consumers, which boosts purchasing power, stimulates the economy, and supports full employment.
Reality: Inflation reduces consumers’ purchasing power by raising the prices of goods and decreasing the value of each dollar.
In the policies we’ve discussed so far, we’ve seen that every dollar that goes to one effort is a dollar taken away from something else. In order to get a complete picture of the effects of various policies, we must consider not just the allocation of money, but also the value of money, which varies based on inflation.
Inflation is the result of the government taking on a cost that it can’t pay or doesn’t want to pay with tax dollars, so it simply prints more dollar bills. Many people mistakenly believe that more physical dollars equates to more wealth, and they often promote inflation as a way to:
However, this view confuses money with wealth. Money is just a medium for bartering goods. On the other hand, wealth is the value of everything that is produced and consumed, meaning that wealth can’t be increased without increasing the production of goods. Inflation doesn’t increase production, but rather the amount of money circulating.
To illustrate the effects of inflation, consider this example:
This effect continues to ripple out until it has reached everyone in the country. Eventually, everyone reaches a higher income level—however, since prices rise proportionately to the rise in incomes, collective wealth does not grow. Furthermore, the groups whose incomes increase early in the process have the opportunity to use their money to buy more goods before price hikes catch up, while others have to deal with rising prices before the pay raise reaches them. This is what the discrepancy looks like for the example above:
If inflation only continues for a few years, the rise in incomes and prices eventually equal out among all groups—but Group D never regains what it lost to high prices during inflation.
Additionally, because of the common confusion between money and wealth, inflation allows the government to deceive taxpayers about the true costs of projects paid with deficit spending. People measure monetary worth by dollar amount—they know that their paycheck is $2,000 and their house cost $250,000. However, when inflation changes the value of each dollar, people may not grasp that their wealth has decreased despite the fact that their paycheck is now $2,400.
If the government pays for a public works project with deficit spending instead of taxes, it can veil the consequences we discussed in Chapter 4, including decreasing the public’s purchasing power through taxation. However, the government will eventually have to repay the debt by imposing heavy taxes, or else it will let inflation take hold, which is also punishing to consumers. In this way, inflation is like another form of taxation, because it reduces consumers’ purchasing power—but, as our example illustrated, it is far more taxing on some groups than others.
Inflation attempts to increase workers’ purchasing power by putting more money into their pockets, so that they can buy more goods. However, inflation only serves to raise production costs through increasing the cost of labor, which raises prices on goods and ultimately decreases workers’ purchasing power, because the same amount of money buys fewer goods.
Fallacy: Saving money doesn’t benefit national productivity and wealth because it’s not being spent directly with businesses.
Reality: Saving money in banks or through investments increases national productivity and wealth.
As we’ve discussed, when consumers spend money on goods and services, they are supporting that business, the wages of its employees, and its productivity. Some economists have stated, then, that saving money deprives the economy of the boost that spending creates—but this incorrectly assumes that savings sit idly in a vault.
In reality, people either save money through investing it or putting it into a savings account. Investments directly support industry by injecting money into a business and enabling it to buy capital (such as factories and machinery) to increase production. Banks use deposited money to fund loans for businesses, which enable those businesses to also invest in capital. In either scenario, savings increases the capacity for production, which increases employment and collective wealth.
In fact, savings does more to increase production capacity than direct spending does. To illustrate this, consider the difference between two brothers who receive inheritances that provide each one $100,000 per year. The first brother, Adam, spends on gifts, luxuries, and services that not only use up all of his cash, but also some of his capital. After several years, Adam is broke and has no money left to support the economy or himself. By contrast, the other brother, Brian, spends $50,000 a year and divides the rest between investments and a savings account. By the time Adam has gone through all of his money, Brian’s investments have grown his income, which allows him to continue supporting productivity and employment through his savings and further investments.
If a large portion of the population suddenly stopped saving and began spending that money on goods instead, the increased demand would raise the price of consumer goods, and the decreased investment in production would lower the price of capital goods. In the short term, the job losses in capital goods industries would increase unemployment; in the long term, this shift would reduce overall production.
Often, people believe that saving money does nothing for the economy because they are thinking of saving as hoarding money—as in, stashing cash in shoeboxes and under mattresses. This kind of saving typically happens after an economic downturn, when people are reluctant to spend or invest because:
Similarly, banks hold money without lending or investing it only in response to an economic downturn, when they fear that the economic instability makes potential investments too risky. People often blame cash hoarding for causing and prolonging economic depressions, but, in reality, it is the result of economic depressions—the real cause is instability created by government policies. Cash hoarding accounts for such a small percentage of the total money in the country that its impact on the economy is generally insignificant.
Interest rates equalize savings and investments in the same way that prices equalize supply and demand. Interest rates are simply the price of loaned capital. When savings rise, banks can offer lower interest rates to borrowers, which enables more businesses to take out loans in order to invest in capital.
On the other hand, fears of high interest rates often raise concerns that companies will be unable to borrow and invest in improving production, and that this will reduce output, employment, and collective prosperity. In response, the government may impose policies that artificially lower interest rates—but the impacts of this tampering are the same as price-fixing:
Additionally, the only way for the government to create artificially low interest rates is to substitute real savings with bank credit or newly created dollars. As discussed in the last chapter, creating money brings inflation, which lowers the value of the money being borrowed. When lenders see the value of money decreasing, they raise interest rates to compensate for the fact that the money they lend will be less when they get it back. In other words, policies that artificially lower interest rates eventually lead to higher interest rates.
The policies we’ve reviewed—from tariffs to rent control—illustrate the harm that can be done by looking only at the short-term impacts of a policy on one particular group of people, and neglecting to recognize the long-term effects on the entire economic system. With this in mind, here are some final thoughts:
The second edition of this book was published in 1978, three decades years after the original. The author reflects on how the policies he explores have been pursued in the intervening decades, and he concludes that not only are the harmful policies still being imposed, but they are more deeply embedded into the economic system of the United States and many other countries in the world.