top of page
Search

Economics in One Lesson: An Analysis of Basic Economics

Updated: Jul 31, 2024

As a layman looking for a primer on all things economics, Henry Hazlitt’s promisingly-titled ‘Economics in One Lesson’ seemed just what I needed to grasp of the complexities of economic theory and its real-world effects.


First published in 1946, the title is a bestseller that aims to de-mystify the invisible architecture of the economic structure that defines our modern world. In a concise, no-nonsense style, Hazlitt (an American journalist) broadly argues in favour of free markets and capitalism, and against the effects of government intervention or actions that might interfere with the proper functioning of a largely self-regulating system; a system that uses carrots and sticks to corral the common citizen along the right path towards freedom and prosperity (and away from what Hazlitt deems the failures of politicians and the prevailing orthodoxy of economic policy).[1]


In this article, I’ll use the book as a starting point for a broad examination of our economic system, and try to understand how economics can, or should, impact human happiness and wellbeing.


So, just what can you learn about economics in one lesson?


What is an economy?

An economy is a broad term for all activities that contribute to the collection and use of resources involved in production, consumption, and trade, and the system that directs and controls such activities.


Organised economies have existed since the time of Sumer and Babylonia and have been instrumental to the rise and fall of empires. Today, when we talk of an economy we typically mean big business, centralised governments and banks, free markets, cheap fuel, and fiat currency; a machine driven by machines underlain by various theories of organising the means of production.


Most of us participate in an exchange economy with relatively free markets; that is, a highly interdependent web where human action is largely predictable because of incentives and disincentives that drive behaviour (for example, people generally buy more goods if they are cheaper, or save more when interest rates are high and money is more expensive).


Our economic ship is led by a crew comprised of government, captains of industry, and economic experts who attempt to navigate the rocky shores of recession and violent storms of the business cycle by using tools like ‘monetary policy’[2] and ‘fiscal policy‘ [3]. Put another way, our economy is like a body whose lifeblood is the movement of capital (financial or productive assets such as equipment), and which survives on the reliable and consistent work of its blood cells (you and I) who must earn resources.


Our economic activity is what gets us out of the door in the morning, puts food on the table, and defines our status and usefulness to society. With this in mind, an understanding of the nuts and bolts of supply and demand and the interplay between interest rates and inflation is not just of interest, but essential.


The Lesson

The underlying ‘lesson’ of the book is that economic decisions at a policy level often lead to unseen, secondary consequences, and we must therefore consider not just the immediate, short-term effects, but also the long-term implications for all groups affected. Hazlitt argues that most people - especially those in charge of economic policy - prioritise short-term concerns due to a lack of foresight or education.


Hazlitt explains through examples that, while it’s tempting to tip the scales in favour of preferred groups, or fight fires with heavy-handed policy, such acts undermine the system's inherent checks and balances and often create the economic disparities or dilemmas they are intended to prevent or solve.


Applying the Lesson (contents):


Government Intervention

Governments intervene in the natural ebb and flow of resources through various acts such as appropriating taxes, spending to stimulate demand, providing subsidies to selected industries, charging tariffs, using price controls (such as minimum wages, rent ceilings, and maintaining commodity prices above market value), and more. But how much influence should a government have over the economy, and how much intervention is beneficial or necessary?


It’s an influence that’s only increased over time as the world has became smaller and government larger and more centralised; in some cases, the government has expanded to have almost complete control over the economy (under collectivist systems), where more overt forms of coercion compel populations to work. Today, most of us rarely second-guess how much government is good in our own society, and generally accept a large, centralised authority having the final say in our affairs.


Hazlitt is broadly against government intervention, which puts him on a collision course with Keynesianism[1] (an economic theory in favour of government intervention in the economy that he describes as ‘discredited’).


Arguments

Public works used to provide employment (as opposed to necessary works) can result in the diversion of resources and value-creation from more worthwhile projects, and reduce possible consumer spending (as such works are funded by your tax dollars). Every dollar spent on public works is a dollar taken from somewhere - and someone - else (and result in unseen lost production of alternative goods or services). Essentially, non-essential public works are a wasteful use of public funds that result in the misallocation of resources.


Excessive taxation can disincentivise production and business expansion, meaning a business is less likely to risk their capital in competitive enterprise where they receive less of the reward from their efforts (especially where financial losses cannot be offset against profits).


Cheap credit provided by government to individuals or businesses encourages inefficient allocation of taxpayer funds to riskier investments less likely to secure the same funds privately on their own merits; such lending diverts capital away from safer investments that are more likely to succeed. Government lending of taxpayer funds lacks accountability and can lead to favouritism and corruption.


Tariffs (when used to increase the price of imported goods) can be used to protect domestic industry but result in inefficient production and misallocation of capital[5]. Hazlitt argues that consumers and markets should be free to reward the most efficient producer (with the lowest costs of production and lowest price), even if this means helping a foreign business to out-compete a domestic producer and local job losses. If the consumer can buy goods more cheaply from a foreign producer, they might spend the money saved on another good domestically; paying a higher price to a tariff-protected domestic producer reduces the real purchasing power of consumers in a similar way to inflation. The foreign producer who benefits from unrestricted free trade, says Hazlitt, will have more foreign exchange reserves to buy domestic goods as imports, and so, in the end, the use of tariffs is counter-productive.


Analysis

Some countries have lower cost structures (including wages), and free trade, along with the idea of comparative advantage, can result in the loss of domestic industries permanently (along with accumulated intellectual capital and experience). A foreign producer may not necessarily be more efficient at first, but might simply have inherent advantages when it comes to paying lower wages or domestic taxes, and a country may become less self-sufficient and independent when it no longer produces certain goods or services. Hazlitt’s assumption that workers can be re-deployed may not be realistic in the short-term. Countries that accumulate currency reserves may choose not to allocate them in a way which is economically reciprocal or favourable to the domestic economy (for example, they may purchase assets such as real estate or important producers).

 

The Price System

How are prices determined in a complex modern economy? What is the price of fish, and how much should you pay for fuel? It’s a question answered differently by different economic theories, though arguably the most successful answer comes in the form of the ‘free’ price system.


Under the ‘free’ price system, prices are determined (or regulated) by the changing relationship between supply and demand; higher demand for goods and services leads to higher prices charged by producers, while lower demand leads to lower prices. The value of any item is its ‘value in exchange’, that is, what might be received in exchange for the item (whether money or other goods and services). Most economies have a ‘mixed’ price system, where government departments or bodies (or essential industries) are able to set prices which affect demand and supply.


Resource allocation decisions are made much easier under this system. For example, investment flows towards the production of goods that are profitable and in demand, and away from those that are less so. In this way, the system helps balances the goals of producers, who allocate their resources to achieve the highest profits, and consumers, who want to buy more of the goods they need.


The idea of the modern price system is opposed by theories such as the labour theory of value, which contends that the value of a good or service is not what is determined by the market (producers and consumers engaging in relatively free exchanges), but (very broadly) by the amount of labour expended producing it; value is determined more by the inputs into a product, rather than the value of what can be demanded in an exchange.


Arguments

Price-fixing involves setting a maximum or minimum price for a good or service. A maximum price for an essential commodity, for example, can increase demand and reduce supply (as prices are not allowed to fluctuate with consumer purchasing power and goods become more affordable to more consumers), reduce producer profit incentive (including all producers in a particular supply chain), and even result in shortages, the opposite effect of the original policy intention. In extreme cases, rationing of goods might be required, and price would become only one component of ‘who gets what’ (the other component being the will of the authority in charge of allocating rations).


Rent control is a policy of setting maximum prices for rent in situations where the supply of housing is too low. Rent control discourages investment in building new homes because it reduces potential rental revenues, and discourages landlords from performing maintenance on existing properties. Artificially low rent prices can allow people to ‘waste space’ by occupying larger accommodations than they need. If owners are allowed to raise rents due to inflation, occupiers can, and often do, adapt by sharing or occupying smaller housing.


Analysis

The situation where rent controls are required acknowledges that the cost of building a new home is unaffordable for those who must rent; those who cannot afford permanent housing rely on the profit motives of investors who possess sufficient capital to build new homes for them to live in. This might be seen as a structural problem in an economy, or a necessary feature that funnels new generations of workers into a nations’ labour force (who must work to afford permanent housing). While some short-term accommodation is necessary and valuable, higher housing prices that create long-term renters dependent on the economic incentives of some means less financial security lower standards of living for many, including those who - despite earning a decent wage - cannot afford, or must defer buying, permanent housing.


A lack of available housing is sometimes described as a ‘supply issue’, or an inability to build enough dwellings for a given population. This claim often minimises demand pressures caused by very high levels of net immigration[6] that outstrip the efforts of even the most productive property developers. First home buyers in Australia, for example, are now impacted by rising interest rates and unwavering demand sustained by recent arrivals seeking a home.


Recent data illustrates the difficulties faced: in Australia, there was a startling 23.7% increase in Property Price Index across capital cities for the twelve months to Dec 2021, and an average price of residential dwellings of $920k[10]. 66% of households owned a home with or without a mortgage (down from 71% in 1994), and 31% rented. Over the twenty years to 2020, housing costs increased 50% for home owners without a mortgage, and 50% for private renters. 20% of households owned more than one property, and 4% owned four or more (that’s around 1 million households and at least 4 million properties owned by them)[11].


Another issue, the impact of which is sometimes disputed, is the amount of property owned for investment purposes. These properties are made unavailable for purchase by owner-occupiers. From the 2022 Rental Affordability Index (RAI), published by National Shelter, SGS Economics & Planning, the Brotherhood of St Laurence, and Beyond Bank Australia:


“Nationwide, the proportion of households renting is on the rise, having increased from 26 per cent to 31 per cent between 1995 and 2020.


…In Australia, this shift towards renting, and increased rental costs, is driven by a range of factors. The introduction of the capital gains discount in 1999, combined with negative gearing has dramatically increased the number of investors who compete with homeowners for available property and kept more households out of home ownership and trapping them in the rental market. Recent interest rate conditions and widening income inequality reinforce this effect.


…Investors have pushed out would-be homeowners, so more households with middle to higher incomes are renting for longer. This impacts lower income renters by driving up rents


…While not a main driver of rental affordability, in some inner-city areas, there are many apartments sitting vacant as an investment. For investors, vacant properties are often held on to for long term capital gains. This reduces the availability of rental properties to households.”


Creating demand through immigration can be an effective way to stimulate the production of ‘higher density’ dwellings in inner-city areas that are often built upon the remains of traditional quarter-acre blocks (I'm sure there's a touching metaphor in there somewhere about the pains of rapid social change), though these dwellings are generally smaller and less desirable than detached homes. Such policies may also encourage locals to leave their home region and travel elsewhere to seek lower-cost housing; this could have a politically-desirable effect of re-distributing population to regional centres.


Foreign investment in residential real estate is historically not well understood in Australia [7], and the most reliable source of information comes from the Foreign Investment Review Board (FIRB), though even this information, which is widely cited in the media [8], comes with significant caveats:


“The statistics contained in this Annual Report do not measure total foreign investment made

in any year, nor do they measure changes in net foreign ownership levels in Australia. They

reflect investor intentions (not actual purchases) to acquire Australian assets that are subject

to the Act. They can be skewed by very large investment proposals and multiple competing

proposals for the same target.”


Despite the lack of clarity, steps have been taken in recent years to enhance the scrutiny of foreign investments, notably by the Foreign Acquisitions and Takeovers Fees Imposition Amendment Bill 2020 [9].


Rent controls are back on the political agenda in Australia, with the NSW branch of the Greens proposing to freeze rental prices and protect tenants against unfair evictions, describing the unaffordability of rental prices as a ‘market failure’ [12]. The policy outline accuses investors of exploiting a housing supply shortage and the party plans to create more public and affordable homes. Such policies require would greater government intervention, and would, according to Hazlitt, undermine market mechanisms that provide incentives for investors to build more housing.


Which is the right view of housing affordability? Is it up to the market to correct the shortage of supply, or must the government protect tenants from avaricious investors? Are unlucky renters feeling the pinch because of bad policy, or is there an elephant in the room? Perhaps, as in many situations involving opposing ideologies, the solution will require some compromise.


Arguments

A minimum wage is a type of price control for labour, intended to provide a ‘living wage’ and prevent unscrupulous employers from paying below-market wages.


Hazlitt argues that setting a price floor for the cost of labour can eliminate jobs that would otherwise be available below the minimum wage, causing unemployment for workers who cannot compete above this rate. More importantly, as higher wages increase the costs of production, this cost might be passed on the consumer through higher prices and cause them to buy fewer goods or substitute products (and harming some producers). Alternatively, the result might be the production of fewer higher-cost goods or services and job losses.


People who cannot compete at the minimum wage (those whose labour is not valuable enough at this price) must rely on government welfare payments. Hazlitt argues that if the welfare rate is too high, workers are disincentivised from seeking employment at all. He suggests that the best way to raise wages is by increasing labour productivity and value through training and education to encourage investment in industry, capital accumulation, business expansion, and greater profits.


Analysis

Should a low-skilled employee who is uncompetitive at the minimum wage be left to earn a meagre existence from low-paid work below a minimum wage? Do we have an obligation to protect people who have low mobility or little education (such as students or those without marketable skills) from the price system?


For Hazlitt it’s necessary to be cruel to be kind by allowing more flexible arrangements between employers and employees; workers are then free to respond to incentives and negotiate the best deal available to them. Within a system that requires people to create value in employment or business (and in which opting-out and escaping to live in the mountains is rarely an option), requiring those with few options to choose a bad one (in the form of a wage that affords a low standard of living) seems, on balance, unfair.

 

Profits

The idea of profits, particularly those made by large corporations, can be contentious. Should there be a limit on how much money a corporation can make? How wealthy should a person be? Examples of excess at the top end of town abound, and we’re all familiar with billionaires like Gates and Musk who have far more than they need. Is anyone really worth the luxury and power than can be bought with millions, or even a billion dollars?


Arguments

Hazlitt argues that exorbitant corporate profits are rare and that many small businesses may take home less than some highly paid employees. He highlights the risks involved in creating a profitable enterprise, along with the frequent failure of small businesses and their loss of capital; behind the glossy veneer of a business venture and the prospects of financial freedom and independence is the reality that risk is required for return; who dares wins.


In a free economy, profits are a sign of economic health and allow firms to expand production, provide greater employment, and direct productive capacity to goods and services that consumers demand the most.


The allure of higher earnings and the need to keep costs low create more efficient and innovative enterprise and force business to remain competitive. Alternative economic systems (that don’t allow a market system to determine prices) do not solve the problem of how to allocate resources as effectively as the ability (and necessity) to make profits under a market system of free trade and enterprise.


Analysis

Around 8% of Australia's labour force are employed by the top 126 publicly traded companies alone [18], and it's interesting to consider whether the distribution of profits within these companies (as microcosms of a hypothetical larger, more controlled economic system) is on a basis that more closely aligns reward and effort, or whether the market does a better job. Do those that shoulder more of the burden of production and provision have a greater claim to each? It’s arguable whether merit is always the deciding factor in the success of those who lurk within the many layers of corporate management (many will be familiar with the especially egregious examples of executive remuneration occasionally highlighted in the news media). Perhaps, therefore, it really is best to remove as much human judgement from the distribution of resources as possible.


While it may be true that very large profits are not the norm when it comes to all businesses, in Australia 64% of all corporate income tax is collected from companies classified by the Australian Tax Office as 'large' [19]. I admit I'm no entrepreneurial mastermind, but I imagine it would be difficult for anyone without significant capital to compete with any of the big guys entrenched at the top of this list. It's debatable whether large profits are concentrated in the hands of too few, but it's unlikely that the market alone can correct such imbalances.


Hazlitt claims that if there is no profit to be made by producing an item, the effort in creating it is misdirected; profit indicates value, and loss indicates a lack of value. Is this true? It could be argued that many items, such as art or significant works of architecture, require significant investment of resources, and, despite not being profitable, still have value. It sometimes seems that fewer items of cultural value are produced in today’s economic age, where activity is focused on efficiency and functionality (or, in other words, economy), however that fact that ‘unprofitable’ items are still produced (even if with questionable aesthetic or artistic value) means there is some disconnect between the premises of a modern economic system and the needs of a human system.


Hazlitt’s point is no doubt valid in industry where thoughts are consumed by widgets and digits, though most would agree that money is not (or should not) be the measure of all things. The need for profit and desire for growth means our human values and economic needs are often in conflict, and the real question in the age of climate change and over-consumption might be less, ‘do we have too much?’ than ‘do we have enough of the right things?’.

 

Savings and investment

When household savings are deposited in bank accounts, they become available for banks to lend to investors (including other households in form of mortgages) [13]. That’s right, your hard-earned money is used by others to make money, not least the banks that charge interest on it.


Without diving too deep into the murky waters of banking and money creation, banks and other ‘deposit-taking institutions’ hold deposits (which, for them, are liabilities they pay interest on) and grant loans and credit (assets they earn interest from). The Bank of England has this to say about how money is created:


“Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money…The reality of how money is created today differs from the description found in some economics textbooks: Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits; In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.”

(https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy.pdf)


Essentially, money is created by issuing debt, and destroyed by extinguishing debt (when it is paid back, that is). Monetary policy (adjusting interest rates in the economy) is the key tool policy-makers use to encourage or discourage the demand and supply of money.


In some countries, banks - a term I’ll use to mean deposit taking institutions broadly - have a requirement to maintain a minimum level of liquid assets in ‘reserve’ to safeguard against risks (such as loan defaults, for example) and satisfy various other financial obligations.


“Capital is the cornerstone of the banking system’s safety and stability. It protects depositors during periods of stress, ensures banks can access funding, facilitates payments and helps banks to keep lending to their customers during good times and bad.”

(Quote from APRA Chair Wayne Byres.


In Australia, the requirement for statutory reserve deposits was removed in 1988, and banks are now required to hold a certain amount of capital to provide a ‘cushion’ against risk. According to Trading Economics, the Bank Liquid Reserves-to-Bank-Assets Ratio was 16.47% in 2021, an increase on recent years [14].


From a prudential regulator’s perspective, capital is a measure of the financial cushion available to an institution to absorb any unexpected losses it experiences in running its business. For a bank, such losses might include loans that default and are written off. Insurers might be hit by an unexpectedly high volume of claims in the wake of a major natural disaster.


As financial institutions are in the business of taking on risk, managing capital effectively is a very important function. Ensuring sufficient levels of capital are sustained in good times enables a financial institution to remain resilient during periods of financial adversity, and help to protect their customers in the event that it becomes insolvent (which in practice has been extremely rare in Australia, but has been more common in many other countries).


The concepts of saving and investment at the economy-wide level are a little more complicated, and involve international trade; imports, and exports.


“National saving is the difference between a nation's income and what it spends on the consumption of goods and services, and comprises household, corporate and government saving. The level of national saving has important implications for the economy; it provides a source of funds available for domestic investment, which in turn is a key driver of labour productivity and higher future living standards. In an economy open to trade and capital flows, the difference between the level of investment and saving in the economy is equal to the current account balance.”

(https://www.rba.gov.au/publications/bulletin/2012/mar/2.html)


Talk of a ‘current account deficit’ will be familiar to many in Australia (the current account is the net flow of money from international trade), because Australia has long spent more than it makes from overseas trade. A deficit can indicate greater foreign ownership of domestic capital, though having a current account deficit (as Australia had for forty-for years between 1975 and 2019), is not necessarily a bad thing, and could be interpreted as a country like Australia having many investment opportunities that can’t be satisfied by using its own capital (that is, there is not enough savings available domestically to pay for them).


Historically, Australia’s international trade long prospered on the back of the humble sheep (until the 1960’s, wool was Australia’s largest export at 40% of the total), and more recently from resources - primarily iron ore, coal, and liquefied natural gas (LNG). The country’s largest export partner is China (35%), followed by Japan (16%) [15].


A deficit (the amount owed to trading partners), is ‘balanced’ through the Capital Account, which is the other component of the ‘Balance of Payments’:


Balance of Payments = Current Account + Capital and Financial Account


The Capital and Financial account is how a country like Australia pays other countries for giving it more than it provides through direct trade. It is the ‘other side of the entry’ just like in accounting, where each transaction involves two parts: a debit and a credit. The total balance of payments should be zero [16].


Finally, when talking of trade, it’s useful to remember that transactions can only take place when one party has enough foreign currency to pay the other, so exporting to another country helps a nation pay for imports.


Arguments

Savings and investment are two sides of the same coin; savings is the supply of capital and investment the demand for it. The amount of savings deposited in bank accounts is available to investors, who can use the idle funds in the form of bank loans and credit.


The level of savings and investment are brought into equilibrium by using interest rates (the price of capital), which makes money cheaper when rates are low and costlier when rates are high (and savings or investment therefore more or less attractive).


A high rate of interest is not to be feared, and is a stimulus for greater savings, whereas an artificially low rate can encourage wasteful use of capital on less-productive ventures and allow households to overstretch their finances. Excessive lending can create inflation where banks increase the money supply and are eventually accompanied by a rise in rates as lenders compensate for the decrease in the value of money due to the effects of inflation.


Unproductive savings generally only occur where cash is simply hoarded, or where economic uncertainty that causes banks to tighten their lending and households to hold on to a buffer in their bank accounts.

 

Inflation

Inflation is a feature of the modern economy - sometimes called a tax – that is not only tolerated by the powers-that-be, but actually has a target (often two to three per cent). Inflation refers to a general rise in prices throughout an economy and, despite its often-bad reputation, is a reliable companion of central banking policy. A central bank aims to keep inflation at a level considered to be ‘just right’; somewhere between providing a boost to the economy and avoiding a bank-run.


“The Reserve Bank uses an inflation target to help achieve its goals of price stability, full employment, and prosperity and welfare of the Australian people. This is because price stability – which means low and stable inflation – contributes to sustainable economic growth. Targeting inflation of 2 to 3 per cent avoids the many costs to the economy from inflation that is too high or too low.”


Interest rate targets are a bellwether for those set by banks and affect broader economic activity. Central banks control the interest rate for lending between commercial banks who can, and do, ‘pass on’ the higher cost of money to the rest of us, creating a knock-on effect for various decisions made by businesses and consumers about things like lending, saving, investment, employment, and spending. Adjusting interest rates in such a way is a key part of ‘monetary policy’.


Another tool of monetary policy is the expansion of the money supply, which in practice often occurs by the central bank purchasing debt from the government (in the form of ‘bonds’, which are essentially loans made to the government). Increasing the money supply is considered by some to be a contributing factor to inflation.


“But central banks are not like commercial entities. Unlike a normal business, there are no going concern issues with a central bank in a country like Australia. Under the Reserve Bank Act, the government provides a guarantee against the liabilities of the Reserve Bank. Furthermore, since it has the ability to create money, the Bank can continue to meet its obligations as they become due and so it is not insolvent. The negative equity position will, therefore, not affect the ability of the Reserve Bank to do its job.”


Money is created by banks by making new loans from money that did not previously exist and, in the same way, when banks make fewer loans and existing loans are paid off, the money supply decreases:


“From the perspective of money ‘creation’, deposits can also be created when financial intermediaries make loans. While the process of extending loans is central to the process of money creation, this does not mean that financial intermediaries are able to make loans and create money without limits. Deposit-taking institutions need to meet certain regulatory requirements and must be satisfied that borrowers can pay back their debts.

Deposits can also be created by the Reserve Bank, such as when the Reserve Bank purchases government bonds. When the Reserve Bank purchases government bonds from the non-bank private sector, households and businesses ultimately deposit the proceeds of the sale into the banking system, adding to total deposits.”

(https://www.rba.gov.au/education/resources/explainers/what-is-money.html#fn1)


Inflation is generally measured by changes in the Consumer Price Index (CPI) – that is, the price of household goods and services (which does not, interestingly, include buying and selling existing housing, and therefore excludes the effects of the rapid real estate price rises experienced by first home buyers in most major cities). There are, however, other measures of inflation such as the wage price index, the producer price index, and the residential property price index. For the record, the annual growth in wages hovers around 3-4% in Australia, while residential property prices rose over 24% across all capital cities to December 2021. [10]


The causes of inflation are disputed, differing on whether it is an increase in the money supply, or demand and cost pressures in an economy that are mostly to blame. Regardless of the cause, once prices begin to rise in some parts of an economy, inflation generally spreads by producers adjusting their prices upwards in response to higher demand or input costs, followed by workers demanding higher wages.


The primary negative effect of inflation is to decrease the purchasing power of currency already held; consumers can buy fewer goods and services with the money they have saved because, on the whole, prices are higher. Each unit of currency is worth less than before. The effects of inflation are not equal across the economy, and some industries and sectors benefit from higher prices; for example those that own tangible assets such as housing and other property.


The positive effects of inflation include the ability of producers to reduce the real wages of workers when needed (yes, you read that right). This occurs when wage growth is lower than the increase in prices. An important and related concept is that of ‘real wages’; this is the amount of goods and services a wage can afford, as opposed to nominal wages, which is simply the money value of wages. As a rule, when wages rise less than inflation, wage-earners are losing out.


Arguments

Money is often confused with wealth; if everyone had more money, then we’d all be wealthier and be able to buy more things. But Hazlitt describes such thinking as ‘naïve’ because it doesn’t consider the inflationary effects of an increase in the money supply. Similarly, those who advocate for policies to print more money either misunderstand that more money will also, over a period of time, increase commodity prices. Others believe that such policies will have a positive effect on the economy.


Real wealth is goods and services - what we produce and consume. Money is simply a means to an end and a measure of value, but has little value in itself; we can’t eat it, wear it, or drive it.


More money does not mean more wealth, because prices increase as result. Increasing the amount of money raises prices in a chain of cause-and-effect: the first recipients of the additional money uses it to buy more goods and services, the sellers who receive the money respond to higher demand by increasing prices, other people will react to news of inflation, and the process will continue throughout the economy until a general rise in prices occurs.


Inflation is really like a tax, the effects of which are distributed unevenly and disproportionately affect the poor, whose cost of living remains the same while the prices they pay increase. Inflation results in greater wealth inequality because those who are late to the party and don’t receive the early benefits of the extra money (when the prices of goods and services has not yet adjusted upwards); in the short-term, the average consumer continues to receive the same salary.


Productive resources are misallocated as a result of demand created from those who benefit from the initial increase in purchasing power. In addition, inflation can contribute to the onset of recession or depression by causing a misalignment between wages, costs, and prices (for example, between the cost to produce a good and its sale price) and thereby reducing the incentive to produce.


Analysis

While money may not be the source of all wealth or the root of all evil (a claim based on a misquote from Bible which condemns the love of money), it’s useful to consider what money is when discussing issues like inflation, if the rate of inflation is influenced by the quantity of money in an economy as well as the price of money (set by the rate of interest).


Is money something that must, or should, be tied to a tangible commodity (like gold) to prevent it being manipulated and devalued, or is it just an abstract concept that gets its value by virtue of being issued by the authority of government (otherwise known as ‘fiat’)?


In the past, the devaluation of a currency occurred when authorities ‘debased’ it by reducing the size of coins or minting larger quantities of coins that contained less of a precious metal such as silver or gold. The Romans are known to have been sneaky silversmiths and the Chinese tinkered with their legal tender by printing more paper notes.


These days, central banks are fairly transparent about fiddling with fiat currency, which is no longer tied to a tangible commodity and derives its value from being issued by a nation’s central government (and based on the expectation that the nation will continue its economic activities – that it’s workers will continue to work). Consumers are using less cash and transacting with cards instead, a trend that’s only increased since the recent pandemic [17].


Some central banks have begun issuing digital currencies, an enticing prospect for regulators and bankers alike, with a range of potential benefits such as increasing control over tax collection, greater and more direct control over economic activity, and the ability to monitor and restrict consumer transactions for a range of economic and political purposes.


Greater government control over money and economic activity is an alluring idea for some and evokes dystopian visions for others. It seems true that a gold standard, for example, limits government intervention in the money supply as the money supply is backed by, and convertible into, physical gold (in theory, at least), but also that its total quantity is difficult to predict or control.

 

Conclusion

Economics is a complex and challenging field that seeks to understand and control the many variables that impact productive efforts and the path to prosperity for nations. It attempts to analyse how people are motivated to engage in economically-productive activity that is not in their direct interest, and is a discipline whose study spans human behaviour, psychology, and history.


While it might take more than one lesson to learn the ins-and-outs of economics, Economics in One Lesson is a good place to dip your toe into the waters of a field that affects us all.


Concepts and definitions

Fiscal policy is the use of revenues collected through taxation and government spending to influence economic activity and other indicators such as consumer demand, unemployment, and economic growth (most often measured by Gross Domestic Product or GDP per capita).


Anyone who pays attention to the news at ‘budget time’ will have heard about balancing payments, receipts, reducing debt, and the various ways in which the government plans to achieve its objectives. In Australia, government income is mostly comprised of individual income, company, and consumption taxes, and mostly spent on social security and welfare, health, and various other government initiatives.


Monetary Policy is controlled by a county’s central bank, who set the interest rate payable between banks who lend short-term deposits to one another at interest. This interest rate influences other interest rates in the economy (such as mortgage lending rates) and in this way helps control the rate of inflation by making money more or less expensive and borrowing and saving more, or less, attractive to businesses and individuals. For example, businesses or individuals with large amounts of debt (such as a household mortgage) will spend more to pay off their debt when rates are high, and more on other goods and services when rates are low.


Monetary policy is primarily used to control the general level of inflation in the economy, along with the rate of employment and the stability of the currency.


References and resources

Key economic concepts (Reserve Bank of Australia)


Causes of inflation (Reserve Bank of Australia)

Central bank inflation target (Reserve Bank of Australia)


Inflation (Wikipedia)


CPI FAQ’s (Australian Bureau of Statistics)



Taxation Statistics (Australia Tax Office)


Rental Affordability Index


Report on Foreign Investment in Residential Real Estate (Parliament of Australia, 2014)


Real-world policy example of rental price controls


APRA - Capital


Banking Capital Requirements (APRA Act Australia)


Australia Capital Requirements


APRA – Capital Explained

Foreign Investment Review Board - 2019-20 Annual Report


Bank of England - Money creation in the modern economy (2014)


Article: ‘Repeat After Me: Banks Cannot And Do Not "Lend Out" Reserves’


Article: Is Australia set to return to current account deficit due to weaker exports?


Do Current Account Deficits Matter?


Trends in National Saving and Investment


The Balance of Payments


Footnotes [1]The line between economics and politics is often blurred, and according to Wikipedia the book has had wide and ongoing appeal with political conservatives and libertarians. The author himself describes the content as “unblushingly ‘classical,’ ‘traditional’ and ‘orthodox’”. Hazlitt acknowledges the works of Frederic Bastiat and Ludwig von Mises, whose works remain influential.

[4] A theoretical concept that outlines a pragmatic arrangement between government and governed (who are assumed to offer their consent to surrender certain freedoms to authority). https://en.wikipedia.org/wiki/Social_contract

[5] Tariffs are used to protect domestic producers in a system of international free trade. According to Classical economic theory, the specialisation of labour and comparative advantage (each producer doing what he does best) result in an overall increase in productive efficiency and output and improve the general standard of living.

[7]“…foreign purchases change a bit from year to year, they have generally remained low as a share of the total value and number of houses turning over. Nonetheless, the data on foreign purchases are limited, and a case could be made to publish more granular – and more timely – statistics, especially data that are already being collected by FIRB (Foreign Investment Review Board). The data and liaison suggest that foreign residential investment is concentrated in some parts of the housing market, though not generally in the parts where first home buyers have a major presence.” (https://www.rba.gov.au/publications/bulletin/2014/jun/pdf/bu-0614-2.pdf) “As there is no appropriate source for the collection of data on foreign investment in real estate, the ABS series in relation to foreign investment in real estate is compiled using a combination of ABS collected and estimated data…The ABS focuses on the need for strong source data to assist in meeting high quality aggregate data requirements for fiscal and monetary policy needs and therefore, is not in a position to provide an evidence base for detailed analysis of foreign investment in residential real estate.” (Australian Bureau of Statistics (ABS): Submission to the House Economics Committee inquiry into foreign investment in residential real estate, 2014)

[12] https://greens.org.au/nsw/news/media-release/greens-announce-rent-controls-freeze-and-cut-rents https://greens.org.au/nsw/freezeandcutrents2023



[19] https://www.ato.gov.au/General/Tax-and-Corporate-Australia/In-detail/Demographics-of-large-corporate-groups/


Kommentare

Mens-School_1_v2.png
bottom of page