Investment | Basic Economics by Thomas Sowell | Ch. 13 | Part 1

We've arrived at Part 4 of Thomas Sowell's Basic Economics. In this part, we're going to be exploring the idea of time and risk in the market, and how these things affect the allocation of scarce resources that have multiple uses (i.e. economics!).

In chapter 13, we begin by talking about investments. If you want to see what my previous summaries are for this excellent book, please click here. Otherwise, let's begin!

Note: This is a VERY LONG chapter. Consequently, I'll be doing two parts for it.

Disclaimer: Because of the nature of this chapter and (probably) future ones, I must make it clear that NONE of what I write or summarize in any of my blog posts should be construed as financial advice of any kind. This is all here purely for educational purposes.

Chapter Summary

In talking about investments, time may be the most fundamental of all 'scarce resources with multiple uses' to be allocated. When thinking of investments, this means sacrificing real things in the present so that more things can be had in the future. Since we're dealing with an unknown future, investment is always going to take some form of risk.

The reality is that almost anything is an investment. In the case of artists, the time they invested in improving their skills and education was an investment. Thus, when students apply for loans for higher education, they are asking banks or the government to take a risk to invest in them, so that their future work resulting from their education would repay this investment.

This isn't about morality, but simple economics. There is no obligation to force any investment to be paid off, because the market determines whether any investment has value in society. If an investment fails, it should not be paid off, because that actually means it isn't needed or demanded by consumers. A failed investment is a signal that others need to stop making such investments.

Let's look at two different kinds of investments.

Kinds of Investments

HUMAN CAPITAL is a form of investment which includes education, though that isn't the only form. Yet, education in modern industrialized nations is often the most emphasized. While most people recognize that education has contributed to better economic development and better standards of living, this isn't to say that all forms of education have equally contributed to such things. This is because practical subjects such as mathematics and medical sciences are not the same as literature and art, the latter of which may not produce skillsets which can more immediately add benefit in society.

When we look at Third World countries, we can see a difference between people who have been educated and those who don't. Those who have a lot of schooling, yet no 'economically meaningful skills' are actually a large source of the unemployment in these nations. Thus, such people are often hired into government or bureaucratic positions, so as to avoid their eventual civil unrest due to joblessness. These bureaucrats are then responsible for the masses of laws and red tape that become obstacles for those who often do contribute to the country's economy in a more direct way (through their labor or entrepreneurship).

It's important to recognize that much of what we're used to in modern society wasn't born from people who were 'highly educated'. As Sowell points out, the airplane was invented by bicycle mechanics with no higher education, electrical inventions were invented and promulgated by Thomas Edison (who had only three months of formal schooling), and many other things besides. Even now, we can see that businesses like Apple and Microsoft, which have enormous influence on the tech world, were started by people who also rejected higher education. Thus, it's not that education is necessarily bad, but lots of schooling doesn't always lead to better economic (and thus societal) development.

FINANCIAL INVESTMENTS are another type of investment. This is when people take the money that they could spend on current goods and services, and instead put them in something in the hopes of receiving back more in the future. In a broader sense, this basically means investors are allocating resource to resource producers (e.g. factories, ships, dams, etc.) rather than the products themselves in the hope that such producers could make more products in the future than presently.

The vast majority of investments come from large institutions like banks and insurance companies. More importantly, what these large institutions do is allow the little guy to participate in the larger economy to make gains from it, despite not necessarily knowing all the intricacies of those different products, assets, and services. Thus, they often have large collections of capital at the ready, funded by stock holders and depositors. They further allow borrowers and lenders to come together to effectively take future income (i.e. credit and interest) to pay for the present. The truth is that all money that is stored with third parties (i.e. banks, etc.) participates in this process, since depositors' money is almost always being lent out to other people and businesses.

Thus, we often see that countries without the ability to allow institutional investment en mass are unable to generate wealth very quickly. It's not that necessarily that there is a lack of ideas or entrepreneurship, or even that these countries are poor to begin with. After all, many great inventions came from people with modest beginnings (e.g. Henry Ford, Hewlett-Packard, etc.). Such inventions that affect us today, however, were also situated in societies in which financial institutions could readily allocate resources to support them. As Sowell notes:

It is not that the wealth is not there in less developed economies. The problem is that their wealth cannot be collected from innumerable small sources, concentrated, and then allocated in large amounts to [any] particular entrepreneurs”

Since these large financial institutions are difficult to understand, many people have a low opinion of them. Yet, their fundamental role of redistributing resources in society is not to be taken lightly. The vacuum left in the wake of their departure is often societal decline and poverty.

Returns on Investment

For the most part, people are hoping for a positive return on their investment. This can even include raising children, in the parents' hopes that their kids will one day either take care of them in their old age, or at the very least be of benefit to society as a whole. In this way, the continuation of generations of human life can be seen as the most basic form of investing.

A lot of people talk about investors having “unearned income”, since they may not see any contributions an investor makes in the present. However, oftentimes, an investor took a risk several years prior to put money into building a factor, and is only now earning dividends or income from it. They also took the time to make sure there was good management, proper suppliers and distributers, and other things that determine whether their investment succeeds or fails. In this way, risks taken by investors are often invisible, but no less important than the visible creation of a product. Thus, the idea of workers being the only ones who create wealth is very untrue.

In the same way, money-lending is often derided in society. And thus, laws are often created to help borrowers have more time or latitude to repay loans. But we need to remember that loans are made because someone is already taking a risk in giving their money out. By making it more difficult to collect on due debts, the law is actually hindering people's ability to help others make products that may benefit society as a whole. That is why lenders charge interest — it is a charge for accessing the investor's funds, which are then used to make the new service or products.

In this way, we can see interest rates as measures of supply and demand for investing. When interest rates are low, people tend to save less and borrow cheaply. When interest rates are high, the opposite happens, and borrowing becomes more expensive. In a free market, lenders will decrease interest rates to incentivize borrowing, or increase them when they see a lack of supply. However, when government entities set rates, they affect unintended parts of the economy.

For example, in the early 2000's, the U.S. Federal Reserve lowered interest rates to try to save decreasing employment and production growth. The lower rates led to lower mortgage payments, which increased the price of houses (due to demand) and reduced the price of rent in apartments. People also began to save less. These unintended consequences show how connected everything is in an economy.

As a final note in this section, it's important to understand that interest rates are often correlated with the time a loan is meant to be paid off. The shorter the time frame for total payment (i.e. payday loans), the higher the interest rate often is (so as to better guarantee payment). Yet, government authorities in the United States often try to put a ceiling on rates. This affects different ethnic and racial groups in different ways.

While many might celebrate the government putting lower ceilings on interest rates, what often happens is that these lower ceilings then block out many racial minority groups in the US from borrowing. This is because payday loaners can no longer charge high interest amounts for high income borrowers (which are more guaranteed) so as to make up for the lower income borrowers who are less likely to pay back. And thus, only millionaires and billionaires, most of whom are not racial or ethnic minorities, are allowed to borrow.

It's not actually about race. Instead, it's the understanding that higher income earners are more guaranteed to pay back their debt. It just so happens that racial and ethnic minorities in the US tend not to be high income earners. After all, in these circumstances, Asian Americans are often allowed to borrow, since on average their income is higher than even white Americans.


My Thoughts

There were two main things that jumped out at me as I read this chapter, having to do with education and financial investment. Let's take a look at these two topics.

Education and Economy

One of the biggest issues in the United States currently is student loan debt for higher education. It's a big issue due to two primary reasons. First, in the United States, the amount of money needed to attend universities at the undergraduate, graduate, and doctorate/post-doctorate levels is insanely high, costing tens of thousands of dollars for even public state-run ones. A large portion of the higher education student population must get a loan from a bank or a similar institution to even attend (let alone get room and board).

The second problem is even worse. While universities certainly have subjects of study which are important and helpful to society, it is undeniable that many majors and minors in universities largely useless. Liberal arts degrees and other similar things, while often stimulating and a great source of enrichment for people's lives, are nonetheless impractical, and cannot guarantee its graduates any jobs. A recent number I saw said that around 40% of US college undergraduates are underemployed when they graduate. This basically means that they are unable to find jobs that suit their degree, and must work lower wage jobs.

As given by the above summary of Sowell's explanations, in terms of economics, this means that colleges and universities are unable to churn out students whose skills are in demand by society at large. In other words, while there is a large supply of workers, since those workers' skills are not wanted, there has been a surplus of workers created. Worse, yet, a surplus of workers who are deeply in debt.

A large movement in the US wants to cancel these student loans, many arguing for full restitution. However, when we understand the basic principles of economics, we realize that cancelling student loans would not actually solve the problem. Why? Because the producers of these low-demand workers will still keep churning low-demand workers out. The problem isn't the debt. The problem is the machine which incentivizes and produces low-skill labor. In this case, the universities, and the system which encourages more and more students to go to them.

The truth is, we simply cannot tell young people that by going to a good school, they can be guaranteed a certain level of income, stability, and security. The world, by and large, moves far too fast for such guarantees to be real, no matter where in the historical timeline you are in. Nothing can replace the real experience of getting into the world, learning to work, enduring both failure and success, and seeing what works for you individually. No education can guarantee anything in the real world.

The Role of Institutions in the World of Crypto

The second thing that stood out to me was the idea of investment and the role which financial institutions play. After reading through Sowell's rationale behind these juggernauts that seem to always be at the foundation of everything wrong with society, I do understand their necessity. However, I do think cryptocurrency may a key to allowing everyday people to have a more personal role in engaging in all of this.

First, I want to make clear that I'm not saying that banks and financial institutions will disappear. Even in the crypto space, there is still a fight between CeFi and DeFi, one which points to the merits of both. To reiterate something I've said before, it seems to me that fully decentralized finance makes lending and borrowing accessible to anyone, and if you're really clever, you can make killing being either a market maker or simply taking advantage of different loan options yourself.

However, most people don't really want to have to mind their finances so closely. We all have day jobs, and everyone would rather be able to pursue their interests and passions. Thus, CeFi services like BlockFi and Celsius Network (and eventually other similar services offered by bigger financial institutions) still have a place. And what I've noticed is that, while DeFi can certainly offer higher returns, those returns aren't stable. If one wants more stable returns, CeFi is by-and-large still the way to go.

It's the argument for specialization (middle-men) which Sowell explained before. There will always be 'middle-men' who can do a better job at something than we can. Thus, for those of us who want to concentrate on other things, their services are actually quite valuable.

That being said, it's easy to understand how DeFi can allow the entire world to begin participating in wealth generation. After all, as long as you have an Internet connection, I can now invest in you, even if I'm in the United States and you're in Africa—or heck, even Antarctica! I can invest using crypto or stablecoin, and through the power of smart contracts, loan that money with interest. All this without requiring any bank or other financial institution.

Such an insane level of freedom of participation is sure to have ramifications for how large investment institutions function, though I can't say I know how, exactly. But it certainly does make me excited to see how this future will play out. Hopefully, for the better.