Free Lunch (2 page)
Authors: David Smith
London, October 2008
This is a book about economics. I realize by writing that I risk losing about half of the bookshop browsers who have picked it up in the hope of coming across something interesting. But hold on. This is also a book about economics quite unlike any other. There are no tricky diagrams of the kind that leaves you wondering whether the page has been printed the right way up. There are no complicated mathematical equations. Unless something can be easily explained, it has no place here. Above all, at a time when we all need to know some economics, it is intensely practical. It will not necessarily make you a millionaire – I always say that the only economists you see driving Rolls-Royces are wearing chauffeurs’ caps – but it will tell you about the process by which we become, mainly, better off. It is also, I hope, good fun.
The aim of this book is to fill a gap, just like a good lunch. For years, at the
Sunday Times
and elsewhere, readers have been asking me to recommend an easily digestible book on economics, either for non-economists or for those whose grasp of it is a little rusty. Until now I have found it difficult to do so. There are some excellent textbooks on economics, some of which I shall recommend later, but they are intended for formal courses of study, with teachers offering a guiding hand. This is different. I hope that many students will read and profit from
Free Lunch
but in a way that complements formal study rather than replaces it. There are, too, some excellent works describing recent economic history but these can be difficult, if not impossible, in the absence of the building blocks. An account of, say, Alan Greenspan’s time as Chairman of the Federal Reserve Board in Washington needs the context of knowing something about monetary policy and how central banks are supposed to operate it. Similarly, trying to judge whether an assessment of the success of Tony Blair and Gordon Brown’s management of the economy is fair or not requires a few basic tools.
Why have I called it
Free Lunch
? It is not, whatever you might think, a sneaky attempt to increase sales by passing off a work on economics as an addition to the ever-popular and expanding catalogue of cookbooks, although that would not be a bad idea. Rather, it is because the one snappy phrase from economics most people will have heard of, even if they are unaware it has anything to do with the subject, is: ‘There’s no such thing as a free lunch.’ You never, in other words, get something for nothing. As I am a journalist often required to lunch, not always enjoyably, it has always been close to my heart. It is such a famous phrase, incidentally, that its origins are unclear. While it is often attributed to the American economist Milton Friedman, of whom more later, the
Oxford Dictionary of Quotations
lists its authorship as Anonymous, first coming into circulation in American university economic departments in the 1960s but making it into print, not in a textbook or learned article, but in
The Moon is a Harsh Mistress
, a 1966 novel by the science-fiction writer Robert Heinlein. It is likely, however, that the phrase was in use much earlier than this. The
San Francisco News
used it in a 1949 editorial, itself reputed to be a reprint of one written in 1938, while the legendary New York mayor Fiorello La Guardia said it in 1934, albeit in Latin. As for the origin of the idea, bars in the west of America commonly offered free lunch to patrons buying a certain amount of alcohol. Those who stayed sober soon worked out that they were paying for their lunch with what they were being charged for beer or whisky.
Does ‘There’s no such thing as a free lunch’ work as a piece of economics? Most of us can think of cases where we have apparently got something for nothing. That bus fare you did not pay, or that £10 note you picked up on the street, for example. But think about it. The free fare has a cost, not just in the risk of prosecution but also in that fare-dodgers mean, in the long run, higher fares for all, including you. As for that windfall £10, I would not pretend that there is some higher economic authority guaranteeing that everybody’s lucky gains and losses even out exactly over time but it is likely that something approximating to that is close to most people’s experience. Any gambler will tell you how hard it is, over time, to stay ahead of the bookmaker; any stock market investor that it is difficult to beat the index consistently.
Let me give you another example of the ‘free lunch’ idea at work. If you have just bought this book, thanks, and you have proved that there is, indeed, no such thing as a free lunch. If you have borrowed it from a friend, you are obliged to them, and your payment will probably be to have to lend them something of yours. If it is from a library, you are paying for it in taxes, or will eventually do so. And if you have stolen it, then shame on you, but you are paying for it with a guilty conscience and you might get caught. My contract with you is that, in return for obtaining this book, by the time you’ve read it, you will know as much economics as you will probably ever need and more than the vast majority of the population. Except, of course, in the unlikely event that everybody else reads it too. That would put me in a monopoly position, although not for long, because economics tells us that we would then see a flood of entrants into the market from similar works. Economics could become the new cookery.
At one level the book is an aid to reading newspapers, particularly the financial pages, and understanding (and being able to see through) the economic claims and counter-claims of politicians. Why are we interested in inflation, the level of interest rates, the balance of payments and the budget deficit, and what do they really mean? Why are we interested in some of these things more than others, and at certain times rather than others? No longer when you see economic stories on the financial pages (and increasingly the front pages) should your reaction be to turn over. The only newspaper or magazine economic reports that should be hard to understand are those that are badly written. When you hear a politician saying that this year his government is spending a record amount on the health service you will be able to scream at the TV, as I do: ‘But that’s been the case virtually every year since the National Health Service was created!’ Every voter should know some economics.
There is, however, more to
Free Lunch
than that. When I urge school or college audiences to study economics, it is not just because some such knowledge is essential for modern living. Rather, it is because the way that economists think about and analyse problems in a logical way is useful in so many areas. Watching economists at work is not always a pretty sight and the jokes about their indecisiveness are legion. President Harry Truman yearned for a one-handed economist because every one that he knew said: ‘On the one hand this, on the other hand that.’ You could, according to the hoary saying, lay every economist in the world end to end and never reach a conclusion. This is unfair, confusing the invaluable ability of economists to be able to see the other side of the argument with an apparent inability to reach decisions. Thinking like an economist means approaching problems in a logical manner, replacing assertion with analysis. This book will not turn you into a professional economist overnight but it will encourage you to think differently about things.
Free Lunch
, like all good meals, comes in several courses. It can be digested at a single sitting, taken a course at a time or, if you like, dipped into from time to time for a snack. I hope very much that you enjoy it.
Many books on economics begin by saying something like: ‘Economics is about the allocation of scarce resources between competing demands.’ Or, according to a very good and widely used textbook: ‘Economics is the study of how society decides what, how and for whom to produce.’ These are splendid definitions and undoubtedly correct as far as they go but they suffer from two important drawbacks. The first is that it is not until you have studied quite a lot of economics that you really understand what they mean. The second is that they are, for me, just too limited. Economics dominates and shapes our daily lives, even when we are not aware of it. It is all encompassing. This does not mean we exist only as economic men and women, or are obsessed by money. It does mean that there is no getting away from economics. We refer, after all, to countries as ‘economies’. I like the definition used by the great English economist Alfred Marshall (1842–1924) who said economics was the study of people ‘in the ordinary business of life’.
Much of it also comes back to food, which is why I like the title of this book. Anne Sibert, head of economics and statistics at Birkbeck College, London, uses a restaurant analogy to explain how speculative frenzies – financial bubbles – build up in the stock market. There are two restaurants in a town, the Ritz and the Savoy. Albert does not much mind which one he goes to but chooses the Ritz. Ben, coming next, is leaning slightly towards the Savoy but, seeing that Albert is at the Ritz, decides that it must be better. Catherine is also persuaded by Albert and Ben’s choice that the Ritz must be the place, and so is David. By the time we get halfway through the alphabet to Mary, everybody has chosen the Ritz and nobody the Savoy. But then Neville, who is next, has a very strong preference for the Savoy, partly because the Ritz is by now very crowded. Olivia, seeing Neville’s choice, follows him, so does Peter, and so do the rest, right through to Zak. And then something strange happens. Halfway through their meal, all those who chose the Ritz hear that everybody else is going to the Savoy. They leave, in a rush, to go from one to another, to the Ritz’s chagrin. Think of all those who initially chose the Ritz as people who invested in dot.com shares a few years ago, and think of the rush to get out as they realized that they had invested in worthless companies, and you have a pretty good analogy for how bubbles build up and are burst.
Anyway, this is holding things up. The waiter is hovering and the meal is about to start. What shall we talk about? According to journalistic folklore, the only thing the middle classes talk about when gathered together at dinner parties is house prices. Whether that is true or not, let us take it as our starting-point.
Houses versus potatoes
Most conversations about the housing market will include several elements. One person will assert that house prices have risen too much and are about to fall, while somebody else will claim that they have a lot further to rise. There is bound to be an argument over whether it is better to put your money into housing or stocks and shares. Everybody will count their good fortune to be already several rungs up the housing ladder and not a first-time buyer struggling to scrape together a deposit for a home. Home ownership was one of the great economic developments of the twentieth century. Roughly 70 percent of people in Britain either own their home outright, or are buying it with the help of a mortgage. Canada, the United States and Australia have similar proportions. In Spain it is a little higher, nearer 80 percent. In Germany it is somewhat lower, below 50 percent, with home-buying usually occurring at a later age. Despite these differences, our obsession with the subject is understandable.
Unfortunately, as markets go, the one for housing is quite complicated. Imagine for a moment that the middle-class obsession was with the price of potatoes, which had risen to a very high level. Both the economist and the non-economist – the former after long years of study, the latter instinctively – would know how to analyse this. If the price of potatoes is very high, many people will decide they are spending too much of their income on them and switch to alternatives, such as rice and pasta, reducing potato demand. High prices discourage people from buying, while low prices encourage them. The effect on potato suppliers is, however, the opposite. High prices are an encouragement to supply more, while low prices act as a disincentive. Of course it may not be possible to conjure up extra supplies instantly, although these days the supermarket chains operate very long storage times for so-called fresh foods. One reason why the prices of fresh produce traditionally varied so much from season to season was because supply varied between glut and shortage, depending on weather conditions and the extent to which farmers had responded to price signals (for example, planting more in response to this year’s high prices).
The point, returning to our dinner table conversation about potatoes, is that if their prices have risen very high compared with competing products, this is unlikely to last. Demand will fall, because other foods look relatively cheap. Supply will increase because it looks as if there is more profit to be made in potatoes. The net result will be lower prices. There’s quite a lot of economics in all that but the only things to remember are, firstly, that whereas the higher the price, the lower in general the demand, the opposite is the case for supply. The second is that prices are determined by the interaction of supply and demand. In our example potato prices will fall by enough to make people want to buy more of them but not by enough to discourage suppliers from increasing their output. The price mechanism really is wonderful, ensuring that supply and demand match up, that the market achieves equilibrium, or balance. Markets tend towards equilibrium, towards the balancing of supply and demand. Remember that and you are well on your way to understanding market economics.
Housing and ‘lemons’
It would be a strange and rather sad meal if the guests sat around talking about potatoes, so let us return to house prices. Many people think that the unusual thing about housing, indeed, is the extent to which prices have risen over time. In the 1930s, while much of Britain was suffering in the Great Depression and prices for everything including houses were falling, a great building boom was under way in and around London, creating suburbia. New Ideal Homesteads sold three-bed semis in Sidcup, Kent, for £250, houses that would now cost you £150,000 to £200,000. Modern Homes sold rather grander properties in Pinner, Middlesex, for between £850 and £1,500. To buy one now would cost between £600,000 and £1m. These changes are dramatic but then plenty of things have increased in price over time. My first pint of beer (consumed at a very young age) cost the equivalent of 10 pence. Now it would be twenty times that or more. Inflation, the rise in the general price level, means that we look back with nostalgia at the prices we used to pay. All that has happened to house prices is that they have risen more rapidly than prices generally – they have outpaced inflation – and there is an explanation for that, which I shall come on to.
What is unusual about housing, a peculiarity it shares with only a few other things such as antiques, fine art and vintage wine, is that its price rises even as you own it. Housing, to economists, is not just something you ‘consume’ – it gives you warmth, shelter and a place to sleep – it is also an asset. Contrast what happens to house prices with other, apparently very solid, products. Most fall in price, either because they deteriorate with use or become obsolete. Try selling a ten-year-old computer. It is well known that if you buy a new car, it will usually be worth about 20 percent less than you paid for it the moment you drive it out of the showroom. A famous article in 1970 by the economist George Akerlof, ‘The Market for Lemons’ – lemons in this case being American for ‘dud’ – explained why this was. In 2001 Akerlof was jointly awarded the Nobel Prize for economics. Any buyer being offered a nearly new car by its owner would immediately assume that there must be something wrong with it, that it is a lemon, and thus will not be prepared to pay anything like the full price for it. This applies even if the car is perfect. Only sellers really know whether a car is perfect or not, buyers can never really be certain. Economists call this ‘asymmetry of information’, but do not worry about the jargon. The effect, as Akerlof explained, was to drive down prices across the whole market. Buyers will tend to assume, unfairly perhaps, that all second-hand cars are ‘lemons’. And as long as this is the case, sellers have little incentive to sell good quality second-hand cars. Interestingly, the big car manufacturers have made an explicit effort to correct this lemon effect in the market by offering extended warranties on new cars and special guarantees on the second-hand vehicles sold by their dealerships.
When we talk about the housing market, we are talking by and large about a second-hand market. New houses are built every year but their number is tiny, perhaps a 1 percent increase in supply in relation to the existing housing stock. The net addition to that stock each year, taking into account properties removed from the market by demolition or conversion into offices, is even smaller. Why, if most houses are second-hand, do they not suffer from the lemon effect? Some, it should be said, do. In the winter of 2000–2001 many parts of Britain suffered their worst flooding for decades. One immediate consequence, experts said, would be that properties in areas prone to flooding would become more difficult to sell, or only sellable at significantly lower prices, because people willing to put up with flood risk would require some compensation for doing so. In the late 1980s, in response to strong demand, Britain’s house-builders built thousands of tiny boxes and called them ‘starter homes’. Like flood-prone houses later, these subsequently became hard to sell. They became lemons.
In general, though, second-hand houses do not suffer in this way. Even if they need money spent on them, as they usually do, and even if that involves more than what might have been revealed by the structural survey, which it usually does, buyers are not deterred, for two reasons. One is that, except in extreme circumstances, the cost of repairs and improvements usually represents only a small fraction of the cost (and therefore to the buyer the value) of the property. The second is that people are willing to spend money on their houses because they see this as maintaining or improving an asset that is going to go up in value. As an aside, a perennial debate in the property pages is whether you ever get back, in the eventual selling price of the house, what you have spent on double-glazing, a conservatory or a kitchen. In other words, does your house sell for a sufficient amount more than the unimproved property down the road? To an economist, that may be a sensible question for a property developer to ask himself, but it does not have a lot of relevance to the ordinary homeowner. This is because the gains from any improvements fall into two categories – the ‘consumption’ of those improvements in the form of more warmth, comfort or space, and the effect on the value of the property. Splitting the two is very difficult indeed, not least because it will vary according to individual preferences.
While we are at it, let us nail another newspaper (and dinner party) favourite. Can you compare the rise in the price of your house and that of investments in the stock market? The answer is no, unless you have a way of valuing the non-financial benefits – warmth, shelter and so on – you have received from housing along the way, which share certificates do not offer. Not only that but, on the other side, most people do not take out a mortgage to buy stocks and shares (although they do forgo the interest they could have obtained from putting their cash in a deposit account). It is a case, though I hesitate to introduce more fresh produce into the discussion, of comparing apples and pears. Even for developers, the calculation is not easy. Most measures of long-run stock market performance assume that share dividends are not taken as income but reinvested. The equivalent for a landlord would be that rental income was immediately invested in additional properties, and the comparison would then be between the rise in the value of an entire property portfolio, not any single house, and that of the stock market.
We have got this far without addressing a rather important question. People are prepared to spend money on their houses, not just because they want to live in more comfortable and spacious surroundings, but also because they think they are investing in an appreciating asset. History tells us that they are right to think that but it does not explain why.
Why house prices rise
One of the most enduring economic relationships is that between house prices and people’s incomes. House prices rise because incomes do. The house price/earnings ratio – the ratio of average house prices to national average earnings for full-time workers – is around 3.5 over the long run, usually fluctuating between three and four. If average earnings are £20,000 a year – they are actually a little bit above that at the time of writing – average house prices will be around £70,000. It is easy to see why this relationship should exist. Suppose house prices had not risen and were stuck at their 1930s level. Someone on average earnings could buy several houses in the London suburbs a year, instead of buying one and paying for it over the twenty-five years of a mortgage. We are back to supply and demand. In this case rising demand does not mean that everybody wants to own a string of houses. It does mean the amount they can afford to pay for their semi has increased hugely and, more importantly, so has the amount others can afford to pay. Competition among buyers, all of whom have been able to pay more over time, pulls house prices higher.
