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“Economics,” wrote Henry Hazlitt in his excellent book Economics in One Lesson (Laissez Faire Books Fiftieth Anniversary Edition, 1996, ISBN: 0930073207), “is haunted by more fallacies than any other [field of study] known to man.” These fallacies can be attributed partly to special pleading. Commercial and economic developments characterised by freedom of choice and voluntary association, as shown beginning in Part II, tend to benefit everybody; but as this circular shows, others (particularly those in which a government has granted a privilege or a benefit or an immunity) benefit a select few at the expense of many. Not surprisingly, says Hazlitt, people who live under “compassionate” governments tend to organise themselves in order to obtain new or to maintain existing privileges. A group with this objective in mind “hires the best buyable minds to devote their whole time to presenting its case. And it will finally either convince the general public that its case is sound, or so befuddle it that clear thinking on the subject becomes next to impossible.” Accordingly, and as the French classical liberal Frédéric Bastiat put it (The Law, Foundation for Economic Education, 1850, 1998, ISBN: 1572460733), under these circumstances “government is the great fiction through which everybody endeavours to live at the expense of everybody else.”
According to Hazlitt, another fertile source of economic fallacies “is the persistent tendency of men to see only the immediate effects of a given policy, or its effects on a special group, and to neglect to inquire what the long-run effects of that policy will be not only on that special group but on all groups. It is the fallacy of overlooking secondary consequences.” Herein lies a difference not just between good and bad economics, but also between good and bad investment. The bad economist/investor sees only what immediately strikes the eye; but the good one also strives to see what lies beneath and beyond. The bad economist/investor sees only the direct, instantaneous and superficial consequence of a proposed course of action; but the good one looks also at - indeed, concentrates upon - its indirect, gradual and fundamental consequences.
Given these two sources of economic fallacies, Hazlitt adds (whether we like it or not and indeed whether we realise it or not) that we are presently experiencing “the long-run consequences of the policies of the remote or recent past. Today is already the tomorrow which the bad economist [and not a few bad investors] yesterday bade us to ignore. The long-run consequences of some economic consequences may become evident in a few months. Others may not become evident for several years. Still others may not become evident for decades. But in every case those long-run consequences are contained in the policy as surely as the hen was in the egg, the flower in the seed.”
Robert Samuelson (“U.S. Turns a Blind Eye to Looming Catastrophe,” The Australian Financial Review, 14 January 2004) provides a sobering contemporary example of this phenomenon. “Just for the record, Washington’s Congressional Budget Office recently issued a report telling us what everyone already knows: the federal budget is drifting into a future of unprecedented tax increases, huge deficits or both.” This budgetary débâcle is no secret because few dispute that a very large number (77 million is a much-bandied figure) of American baby boomers will eventually retire, and because almost nobody - least of all the Boomers - denies that this army of retirees will feed very heavily at the trough of government retirement, medical and other programs. “But in Washington, the CBO’s irrefutable conclusion won’t produce any noticeable reaction because there’s already a clear bipartisan policy concerning the future: forget about it. To leaders of both parties, offending today’s voters with unpopular solutions to future problems makes no sense. Indeed, Republicans and Democrats will gladly worsen tomorrow’s problems to win more of today’s votes.”
Welcome to Keynes Island
The very few Americans who are aware of this predicament (and those Europeans who, if they choose to look, find themselves in an even worse situation) cannot say that nobody has warned them about it. This demographic, budgetary, economic and political mess clearly has important implications for investors. Accordingly, in order to understand its origins and plan their response to it, investors should consider the cautionary lesson of the inhabitants of Keynes Island (whose story borrows heavily from Warren E. Buffett, “The Age-Old Lesson of Static Island,” The Washington Post, 28 September 1982). Residents of this fictitious island, considered as a group, possess three remarkable characteristics: their population remains forever fixed at exactly 100; nothing other than food is produced (a beneficent nature spontaneously provides all other necessities); and the islanders never save. As a result, the productivity of labour never improves (or, more specifically, can rise only as a consequence of foreigners’ saving and the investment of capital on Keynes Island).
These attributes encourage peculiarly (from the point of view of The Robinson Crusoe Ethic Versus the Distemper of Our Times) Keynesian patterns of thought. Say’s Law, for example, is flatly and rather indignantly denied. Further, consumption is revered and capital and investment is taken for granted and sometimes denigrated; accordingly, hedonism is the order of the day, and hard work, thrift, sobriety and probity are mocked. Similarly, capitalists are criticised and scorned, and bureaucrats, technocrats and politicians are lauded. The distinct concepts “price” and “value” are conflated. Aggregates and the collective are preferred to individuals and individualised data. And perhaps most strangely, the rate of interest is something decreed by the state rather than negotiated by individuals on the basis of their varying time-preferences (see Henry Hazlitt, The Failure of the “New Economics”: An Analysis of the Keynesian Fallacies, Foundation for Economic Education, 1959, 1994, ISBN: 157246016).
From the beginning, these conditions and patterns of thinking have produced a distinctive economic system. Let us assume that in order to survive each of the 100 inhabitants of Keynes Island needs 18 ounces of rice per day, and that a worker can produce exactly two ounces of rice per hour. Nine hours of daily labour by all of the island’s inhabitants will therefore supply all of the food that they require. But let us also assume that Keynes Island is an island where “social justice” and “compassion” prevail. Ten of its residents are at least 65 years of age. Accordingly, and with little hesitation (but much prodding by a few residents called “politicians”), the other 90 residents volunteer to do all the work. Ten hours of daily labour in the rice paddies and mill by each of the 90 workers will supply the total requirement of 1,800 ounces of rice. It is therefore agreed that 90 will produce and consume, 10 will consume but not produce - and all will feel secure that he will be able to eat as long as he lives. Each inhabitant is confident this is so because Keynesianism and compassionate politicians tell him that it is so.
Finally, assume that this rice-only régime prevails until it is discovered that a non-nutritional but good-tasting and splendidly-intoxicating wine can be distilled from an indigenous berry that grows abundantly on the island. The terms of the good life are thereupon redefined. The workers are predisposed to agree, and politicians exhort them to agree, that a daily consumption of nine ounces of wine per person per day is fair. It is also deemed just that the islanders of working age will undertake the extra labour required in order to ferment this quantity of wine. Indeed, one evening after a particularly joyous wine-imbibing session, the island’s politicians - far better orators than demographers or economists - agree that all inhabitants reaching 65 years of age will receive a lifetime guarantee of a daily ration of 18 ounces of rice and nine ounces of wine. Retirees are ecstatic and workers are confident that they have been guaranteed (and will therefore receive) a decent standard of living after they reach 65 years of age. They are confident because Keynesianism and compassionate politicians tell them that they should be confident.
At the time it is promulgated, this statutory affirmation of present behaviour and good intentions seemed to be harmless. Indeed, it is regarded as beneficial because it confers an immediate psychic dividend: members of the island’s workforce can be certain (for their politicians miss no opportunity to tell them so) that the benefits awaiting them after they retire will equal the benefits they had provided to retirees.
The Sombre Consequences of “Benevolent” Politics and Keynesianism
Let us say that the years and several generations pass, and that improved longevity and a low rate of birth create an island with fewer (70) producers and more (30) retirees. But the island still requires 1,800 ounces of rice daily for its 100 inhabitants, and the statute that guarantees retirees’ standard of living remains in force. Indeed, over the years this statute and the norms that underpin it have become sacrosanct and virtually unalterable. In order to feed everyone, the 70 workers must therefore toil almost 13 hours per day. Note, however, that if all 70 raise rice then the retirees’ standard of living would fall, and that such a development is forbidden by law. The statutory obligation to retirees mandates the production of 270 ounces of wine per day (30 retirees times 9 ounces per retiree). Let us say that this activity requires the labour of four workers. Working 13.5 hours per day, these four can produce the wine promised by politicians to the retirees. Meanwhile, the remaining 66 can raise the rice required for both workers and retirees in slightly over 13.5 hours of daily work.
Notice, however, that this workday (which is a modest 50% longer than the one prevailing before the iron rice bowl was first decreed, and 35% longer than the one prevailing before wine was added to the sacred list) will leave members of the island’s workforce subsisting upon rice alone. Given the legally-enforceable demands of retirees upon workers’ time, energy and output, in other words, the workers must forego their former ration of wine. Also note that as time passes retirees are not better off: the net result of the politicians’ guarantee is simply that the fewer workers will be working longer and consuming less. If the workers wish to maintain their own standard of living (i.e., rice plus wine) then they must work no fewer than 15.5 hours daily (90 producers times 12 hours = 70 producers times 15.5 hours). Politicians’ “compassion” has, shorn of its lofty rhetoric, revealed itself as a compulsory transfer of wealth from workers to retirees. It gradually occurs to the workers (if not the retirees) of Keynes Island that eloquent and grandiose promises regarding future consumption must necessarily be constrained by the fundamentals of demographics and economics.
The most obvious escape from this trap is greatly to increase workers’ productivity. But that, even a few Keynesians grudgingly acknowledge, would require savings - which is a concept that is either alien to or denigrated by Islanders. How much better, asks Mr Buffett, it would have been if (say) 85 of the original 90 rice growers had worked slightly longer each day and “saved” the labour of five of the more inventive workers? Following the lead of Robinson Crusoe, these entrepreneurs could have devoted this “invested” labour to the production of (say) farm implements. This investment might have yielded rice-producing and wine-fermenting equipment. If so, it would have enabled greater hourly output per worker. Labour released from farming, in other words, could have been engaged in entrepreneurial searches; and if these searches produced useful discoveries, then goods hitherto unknown and unimagined (or greater quantities of goods currently consumed) might have been produced. This increase in productivity, if economic history serves as a useful guide, would have more than offset the drag of seemingly-adverse demographic trends. Under these circumstances, all of the Islanders - including retirees - would have had more to consume and producers would have been working shorter rather than longer hours. But if events had unfolded in that way, then the residents of Keynes Island would no longer have acted or thought like Keynesians.
...continued in Part II
 
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