Thomas Sowell is an American economist and author who holds to a laissez-faire, free market and individual liberty perspective. In this special, he gives a brief summary of his analysis regarding the recent housing boom and subsequent bust where he describes what caused the housing bubble, which he outlines in his highly recommended book: Housing Boom and Bust.

Find more videos of Thomas Sowell at LibertyPen.com

Wealth and the Economy

When it comes to the economy, the most misunderstood concept deals with wealth. Wealth and more importantly, wealth creation is the engine to any sustainably healthy economy. As a result, there are many misconceptions to what ultimately allows for a healthy economy. These misconceptions tend to make many look to simply stimulate the indicators of a healthy economy instead of laying the foundation for one. This, of course, only gives the appearance of fixing economic woes, instead of addressing the underlying issues.

What is Wealth?

In order to know how to create wealth, we have to know what wealth actually is. Many look at an economy as a zero sum game. Where there is only a limited amount of wealth similar to a poker game, where one person can only win, if another loses. However, this is not how wealth works. Wealth should not be looked at as any one thing such as paper money. Indeed, that can be representative of wealth, in the way that someone’s net worth can be calculated in US Dollars. However, wealth in the economic sense of the term is ultimately anything that has economic value. In a society that protects private property rights, wealth is created, not won at the expense of others.

Most importantly, wealth can only be created through production. A simple example of this is that of a baker and shoe maker. The baker can bake bread and the shoe maker can make shoes. Both of these products have real value and each tradesman can presumably create more product than they and their family can consume or need. The excess can either be exchanged, given away or stored as wealth. Money is introduced into this equation as matter of both necessity and convenience. Since, the baker’s goods will eventually go bad and the shoe maker’s shoes may eventually go out of style or otherwise degrade. The excess wealth that is produced can be exchanged for money to be stored for later use. Money allows for one to produce more than what is presently needed and store the additional amount of wealth that is created but not used. However, for something to be considered money, it must have a few important qualities. Money must be a medium of exchange, unit of account and perhaps most important, a store of value.

Fiat Currency and Wealth

Modern currency such as the US dollar surprisingly does not hold all of these properties, because it is not backed by anything of value and therefore can be simply printed in order to fund programs and pay debts. Paper currency that is not backed by anything of value is known as Fiat currency. Fiat currency in fact is very similar to a depreciable asset. Since the tendency of governments or institutions in control of a paper currency is to print more of it, it does not properly store its value. The US dollar has lost 96% of its value over the last 100 years. That means if the shoe maker sold his excess shoes and stored their wealth in the US dollar in 1910, they would be left with $4 dollars of purchasing power for every $100 that they saved.

Fiat currency has been used for centuries and even dates back to the Ming Dynasty in 100 AD. In its history it has always lost value. Paper currency can act as money, but the tendency is for those who issue/control the fiat currency to eventually debauch or devalue the currency. To protect against this, it must be a receipt for something of real value or a standard of real wealth so that the paper currency cannot be printed or issued unless there is a real asset to back it up.

Paper currency has played a major role in our economy for the last 100 years. We have slowly removed ourselves from the ‘gold standard’, where our paper currency was a receipt for gold or silver. The resulting system of fiat currency has been a lynch pin to our economic instability for the past century. It has been used to manipulate economies and fund social projects and wars that the US cannot truly afford in comparison to its true wealth production. While the US has forced manufacturing and other bases of wealth creation to other countries with taxes, regulation and wage controls; the US has maintained its standard of living through debt and printed currency. The US has simply been living beyond its means by ultimately borrowing wealth from future generations.

Economic Stimulus via Debt and Fiat Currency

When economic troubles begin to take root, governments and/or central banks typically respond by injecting more money into the system to keep it going. Again, this money is not true wealth; it is simply the appearance of wealth.

Many falsely believe that the government has an infinite amount money, because it can simply print it or borrow from central banks who print it. While the government does have access to a seemingly endless supply of paper currency, it does not have access of an endless supply of wealth. Real money may not grow on trees, but paper currency apparently does. Through an economic theory called Keynesian economics, government spending is justified in order to “prime the pump” of the economy when all other options are said to be exhausted. The problem with this theory, is that contrary to many politicians’ and economists’ beliefs, the US government will eventually run out of credit if it simply continues to borrow. In addition, the US dollar loses value every time another dollar is printed and put into the system.

When the government tries to stimulate the economy through spending, it acts similar to a millionaire in a small town that is hit by a natural disaster which cripples that town’s ability to generate wealth. As a result, wealth production would suffer until the town rebuilds. The millionaire could begin to give money to their neighbors to help them buy products again and spend money in local stores, which could help ‘stimulate’ those businesses. Then, when the millionaire runs out of money, he could start to borrow more on his good name and give that money to the townspeople as well. However, if that town does not find a way to begin producing enough wealth again, eventually that millionaire will be left penniless and bankrupt; and the entire town will be as well.

This is exactly what the US government has been doing for over 75 years. In an attempt to rescue suffering economies, they look to simply stimulate the appearance of a healthy economy by injecting “money” into the system with debt and printed currency. This does provide temporary relief by artificially stimulating job creation, but like the millionaire in the example before, it does nothing to actually address the underlying problem, which is the loss of wealth production. It doesn’t actually solve the problem, it only masks the symptoms.

Note: there is a difference between the millionaire in this example and the government. The millionaire would be using their own money, which presumably they did not take by force. In addition, unlike the debt which is accumulated by the millionaire, the debt generated by government is owed by the American tax payer in the end.

Jobs Created or ‘Saved’

Many look to simply create jobs in order to ‘stimulate’ the economy. The logic with this simply suggests that if jobs are created and wages are paid, then those employed will spend money on domestic goods and services. This demand for goods and services will then in turn create more jobs. This all sounds good, but the question is how to create jobs in a depressed economy? Government is the logical candidate, because in cooperation with the Federal Reserve Bank or other lenders, it is able to borrow money and operate at a deficit in order to spend money necessary to create these jobs. This is a part of the Keynesian theory of economics known as demand side economics. The father of Keynesian economics best summed up his theory with the following example: You can pay someone to dig a hole and pay someone else to fill it. The fact that nothing productive is occurring doesn’t matter. The spending alone stimulates the economy.

What is missed in this theory is the fact that government does not create wealth. So, it cannot spend money on anything, including job creation, that it does not first take from the economy either through taxes, debt (bonds) or inflation. In most cases, debt and inflation are used in lieu of taxes, because they are less destructive to the indicators of health for the current economy and they also allow politicians to simply pass the tax burden and resulting economic repercussions onto future generations through debt, or by secretly confiscating the wealth through inflation. Keep in mind, when money is borrowed from the Federal Reserve, that money is simply printed. When more paper currency is arbitrarily introduced into the system, this is known as inflation. Inflation should be viewed as an additional tax, because inflation erodes the value of savings. The result then of creating jobs via printed money is simply inflation and an increased national debt. In the end, it doesn’t matter how many jobs that are created or saved, if wealth creation has not been restored, nothing has been done to solve the underlying problem.

Inflation confiscates wealth by diluting the purchasing power of the money outstanding. If you have $1000 in your savings account and the money supply is increased by 100% (ie. the  money supply doubles),  the purchasing power of your savings will drop by 50% or $500. The new purchasing power of that $1000 will be $500. Where did that $500 go? It did not simply evaporate, it was taken by the newly printed currency. It works very similar to stock splits, where if a stock splits 2 for 1, the value of all outstanding shares drop by 50%. In order to offset this paper loss in value, the company will have new shares sent out to the current shareholders to make up for the difference. So, if I have 50 shares of AAPL and the stock splits 2 for 1, I will receive 50 additional shares. However, when new money is printed, we don’t receive checks or money in the mail to make up for the loss in purchasing power. That wealth is simply confiscated and used to fund programs. That is why inflation is known as the invisible tax.

“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some….Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and it does it in a manner which not one man in a million is able to diagnose.”
– John Maynard Keynes, The Economic Consequences of the Peace, 1919

Returning to Prosperity

An economy is simply a system where capital, labor and resources are exchanged. A healthy economy is simply one where the process of exchange is occurring at some nominal frequency. It may be obvious that exchange cannot occur unless there is something to be exchanged. That is why production; or wealth creation, is the basis of a sustainably healthy economy. As production and subsequent exchanges increase, more labor is needed in order to fulfill the demand for further exchange. As simple demands are met for things like food, clothes and basic shelter, as well as increases in efficiencies increase over all wealth production, excess wealth is then available for luxury items and even services, thus furthering economic expansion. Simply trying to create jobs does not necessarily translate into wealth production, however, to the contrary an increase of wealth creation does lead to more “jobs” and a higher standard of living.

America used to be a leader of wealth creation in the world, which produced low cost, high quality goods. Unfortunately, we have taxed and regulated our production centers to the point that many are operating overseas. Everything from manufacturing to domestic energy production has plummeted over the last 50 years, especially relative to demand. If we are to see a return to true prosperity in America, we must look to once again being a leader in wealth creation. This does not happen by the Federal government doing more; instead we need for the Federal government to do less. Private business and individuals produce wealth, the more economic freedoms, the more wealth is produced, therefore a return to economic true freedom is the only path to a sustainable and efficient economy, and true prosperity.

Peter Schiff does a great job in explaining what creates bubble markets and more important, how to recover from resulting busts.

Since government doesn’t produce wealth, it has to take wealth from the economy in order for it to operate. Even at its best, government operates at a net expense to a nation. However, it is a necessary expense, as long as the government protects economic and social freedoms which provide a platform for a stable and productive economy.

There is an optimal level of government, too little and the nation descends into anarchy, where no freedoms are guaranteed and a prosperous economy is not possible. However, too much government results in unnecessarily high taxes to fund it, along with stifling controls and regulation. Since the government takes money from the economy, it is removing capital that could be used to invest in more wealth creation and jobs in the private sector, the result is the loss of productivity (wealth creation), which is the basis of job creation in an economy.

Taxes, in and of themselves are not necessarily destructive and to the contrary are very much necessary to operate the basic functions of government to guarantee those necessary freedoms. However, they can also be a tool of tyrants that can cripple and even destroy an economy when they are too burdensome or when they take capital from the economy and destroy it on unproductive uses.

Politicians seem to think they have found a way around the burden of taxes through the justification provided by Keynesian economic theory.

A Keynesian economist would say that deficit spending stimulates the economy by creating jobs. Their theory suggests that if the government borrows, instead of taxing, and in return spends money, the economy will be stimulated regardless of actual productivity.

John Maynard Keynes, the father of Keynesian economics, explained his theory with this example: You can pay someone to dig a hole and pay someone else to fill it; the fact that nothing productive is taking place doesn’t matter. The spending alone will stimulate the economy.

John Keynes was only partially correct. In his theory, the economy can be temporarily stimulated via the credit of the US government. However, what Keynesians will not address is the long-term effects of this theory.

Logically, this cannot continue indefinitely. In fact, when asking a Keynes about the long run, he was famous for responding , “In the long run we are all dead”. This statement acknowledges the fact that eventually that form of economic stimulus will run out and have adverse consequences, but they brush it off by effectively saying, we won’t have to worry about it because we won’t be around. The problem is that in the long run ‘they’ may be dead, but someone else will still be alive and will be left to clean up the mess.

Keynesian economics debuted in 1936 through the book “The General Theory of Employment, Interest and Money”. The US government has been operating under this theory ever since. It has been a god-send to politicians, because they have been able to pay for ill conceived social programs without having to raise taxes, which is effectively buying votes with the wealth of future generations.

The problem is, we are now seeing the long-term effects, with staggering deficits, a huge National debt and an inflated currency. The government is having trouble continuing that economic policy. Borrowing has become more difficult, even from the Federal Reserve, because they have already printed so much money in response to the current crisis. America’s good credit is wearing thin.

The Austrian school of economics is the primary counter argument to Keynesian economics. It addresses the economy in a much more broad view, including the long run. An Austrian holds that the only way to have an efficient and sustainable economy, is through wealth creation and that environment is best created under a limited government, but one that is strong enough to protect the economic and social freedoms of a free society.

The course of Keynesian theory has not offered a way out of operating a government and an economy without having to face real trade offs. The cost of this theory is coming to light now that the latest keynesian bubble has burst and the American people are being forced to realize the destruction of trying to evade the reality of common sense economics. If America is going to be a sustainably prosperous and wealthy nation, it cannot continue to rely on borrowing wealth from posterity, which only shifts the current cost of government onto future generations. Instead, it will have to return to the principles of smaller government and true wealth creation by private industry.

This is a great summary by John Stossel of how the free market really is the best way to regulate commerce. He argues that government does have a role, but ultimately, it cannot be as efficient or effective as the free market.

The four ways we spend money including the Washington way.