Free Lunch – David Smith

I’ve spent the last few months searching through bookshops in an attempt to find a comprehensive introduction to Economics, a subject which I have become increasingly interested in as of late. However, this search was hampered by my preference for a book which was also fairly non-technical, because if there’s one thing that turns me right off when I’m attempting to learn something new, its mathematical equations!

I then came across ‘Free Lunch’ by David Smith. With its subtitle of ‘Easily Digestible Economics’ it seemed exactly what I was looking for. From the very start Smith makes it quite clear that this book is for the layman, there’s no graphs and no maths. The book is set-out in the form of a dinner-party conversation, with starters, a main course, desserts, and lots of little interludes in-between. Its an odd concept, but one which I think works quite well.

In the first chapter, Smith describes the thinking behind the book, why one might want to study economics, and the history behind the saying ‘there’s no such thing as a free lunch’. He explains how economics impacts on all of us in our day-to-day lives, and how a little knowledge can assist us to think differently about anything money related.

He begins the next section with a discussion on house prices, looking at how supply and demand, along with income levels and the rate of inflation all affect the fluctuations in price. My only criticism is that although Smith explains the concepts very well, he sometimes leaves it a little late, diving headlong into a topic prior to explaining the basics, which might cause problems for someone brand new to the subject material. Smith then looks at the ‘substitution’ and ‘income’ effects, using a fall in interest rates as an example. It goes a little something like this: when rates fall, the cost of housing falls. The substitution effect dictates that some people may use this extra money to purchase a larger house, whilst the income effect treats the fall in interest rates as a rise in income, and borrowers may utilise this extra cash to spend on other products and services.

Next, in the first of several discussions on individual economists, he looks at Adam Smith. Smith was a rather awkward Scottish man born back in 1723, who – along with Friedrich von Hayek – had a huge impact on the pro-market and pro-privatization policies of the British Thatcher government and the American Reagan administration in the 1980’s. One of Adam Smith’s most important contributions to economics was the idea of the ‘division of labour’. This was a concept by which workers should become expertly skilled in a particular aspect of the manufacturing process to improve its speed and efficiency. The division of labour survives to this day – more commonly known as ‘specialisation’ – and the productivity gains Smith envisaged have only improved with the development of industrial machinery.

An interesting theory touched on in Chapter 5 is Milton Friedman’s ‘permanent income’ hypothesis. This was the idea that people will always retain an overall idea of what their permanent (or long-run) income is, and will bear this in mind in the face of pay cuts, where they may draw down savings, or when they receive a large bonus, which they might set-aside for harsher times. Ando and Modigliani’s life-cycle hypothesis also links quite nicely into this theory. This uses pensions as an example, stating that during childhood we are concentrated on spending, we then progress onto accumulating savings through employment, and run these down in old age, with perhaps some left to bequeath to our relatives. This is of course highly simplified, but seems to relate quite neatly to most people’s own personal experience.

After giving us a quick biography of some other perhaps less well known economists, including Thomas Malthus, David Ricardo, William Godwin and John Stewart Mill, Smith then looks at the differences between companies and individuals, and discusses why we require companies at all, using Adam Smith’s division of labour as one of the the main arguments. There is also some interesting discussion on monopolies, with lack of competition and higher-prices for consumers being major reasons why the Office of Fair Trading (OFT) was granted powers to investigate and break-up potential monopolists.

Smith then touches on the growth of on-line shopping and the importance of advertising in building a reputation where lack of a physical shop might otherwise dissuade shoppers from making a purchase. Here he also touches on the subject of Game Theory, a topic which I have a particular interest in. Whole books have been written on the issue, but game theory boils down to the idea that gaining maximum advantage in any given situation depends not just on what you do, but also what others do. The use of game theory in economics comes to to predicting – or somehow finding out – what your competitors are up to in order to maximise the performance of your own business. John Nash, a brilliant American game-theorist, who endured terrible bouts of depression and schizophrenia in the 1980’s, recovered to win the Nobel prize for economics in 1994 by taking on the cold-war game theorists in developing what he called the nash-equilibrium, the idea that a ‘win-win’ outcome could exist in which everyone gained.

In the second chapter covering important economists, Smith turns his attention to Karl Marx. As with Adam Smith, there are various anecdotes and commentary on Marx’s personal eccentricities, but unlike with Adam Smith, he seems quite dismissive of Marx’s arguments. Marx like Ricardo believed in the fundamental importance of distribution and the value of labour. Marx was also interested in the ‘surplus value’ of labour, which would tend to go straight into the pockets of the business owner, as opposed to the worker who carried it out. Whilst I agree with Smith that Marx’s theories have aged quite badly in modern times, he nevertheless has some important contributions to make, and we could certainly learn some lessons for today by reaching back to some of Marx’s ideas.

Chapter 9 looks at Tax. In it, Smith describes some different taxes, the reasons behind government spending and some examples of tax gone wrong. Smith uses the term ‘public goods’ to explain services funded by tax which benefit society as a whole, but which we might not be willing to pay for voluntarily. As an example, would we be willing to pay for the police force if we believed the tabloid headlines about them spending the majority of their time prosecuting middle-class motorists? Possibly not. The other justification given for government spending is ‘uninsurable risks’, an example being a chronically sick person who its doubtful would be able to take out a private health insurance policy. Essentially, the idea of tax is to finance the services which only the government can feasibly supply, taking in aspects of a progressive redistribution of wealth from rich to poor.

If like me you’d always been puzzled as to why certain older buildings have some of their windows bricked up then the answer lies in the Window Tax. As surprising as it may be, between 1696 and 1851 properties with ten or more windows were subject to extra taxation, with some owners therefore deciding to brick up as many as possible to save money, the perfect example of a tax gone wrong if ever there was one. A more recent example lies in the poll tax of the 1980’s, applied by Margaret Thatcher’s government, it acted as an additional tax on local government, with violent protests occurring at the time of it’s introduction. Many people simply decided to remove themselves from the electoral register to avoid paying it.

In this same chapter, Smith also introduces the Laffer Curve, developed in the 1970’s by Arthur Laffer. Laffer theorised that high tax rates could eventually cut tax revenue. It works something like this. A zero tax rate generates no income for government whatsoever, however a 100% tax rate also generates zero income, as there is no point in someone working if their entire wage is consumed by the state. Somewhere in between these two points lies the optimum tax rate, and Laffer demonstrated that a point could be reached where the revenue would begin to drop. Simple when you think about it, but very interesting stuff.

In the last of the profiles of the major economists, Smith looks into theories of John Maynard Keynes. Keynes was a charismatic and highly influential individual, who gained a fair amount of sway over government during his lifetime. He attended the Versailles peace conference in 1919 and warned of the dangerous direction the negotiations were taking, and that the high level of reparations being demanded of Germany could lead to further world war, with many later arguing that he was indeed right.

The General Theory was perhaps Keynes’ most important contribution to economics, and it argued that in time of financial crisis and high unemployment, increasing government spending (which Keynes called ‘priming the pump’), would then – via a ripple effect – trigger growth elsewhere in the economy, ideally in the private sector. Keynes wrote that growth in employment overall would then spur the creation of more jobs, as the newly employed public sector workers spent their wages in the private sector.  Again, like most of the theories in this book, it appears deceptively simple. Contrary to the rather dismissive in way in which he covers Marx, Smith seems to make clear the huge impact which Keynes had in the fields of both economics and international relations. Personally, Keynes’ general theory is my favourite piece of thinking described within the book, and I would certainly describe myself as an opponent of the austerity agenda currently being pushed by the UK’s coalition government as a solution to reducing the deficit.

In the final chapters Smith covers two very interesting topics. Money itself, and American influence on Economics. It isn’t very often you think about why we decide certain bits of metal or paper are perceived as valuable. Smith makes it clear that acceptability is often the most important criteria in this, discussing the interesting fact that those annoying Scottish banknotes which many of us detest are not in fact designated as legal tender, not even in Scotland itself, although Smith states that whether something is ‘legal tender’ or not is fairly irrelevant, and he quotes the Bank of England who state that “acceptability as a means of payment is essentially a matter for agreement between the parties involved”. The book then covers the handover of interest rates from Government to the Bank of England, and how decisions are now made.

Smith then looks to America, which has produced 32 of the 49 Nobel prize winning economists. He discusses how economists such as Milton Friedman emerged to challenge Keynesian orthodoxy, instead promoting free-markets as a solution to financial crisis. Friedman’s take on the 1929 crash was that the Federal Reserve had applied the brakes on the level of money available a little too hard, as opposed to Keynes who had blamed a crisis of capitalism, which could be solved via a public sector stimulus. This argument is mirrored slightly in the present day, with Friedman’s arguments that recession cannot be counteracted by tax rises and public spending appearing to prevail in the UK.

The final chapter is given over to a Q+A session, with discussion on taxation levels, globalisation, the European single currency, along with an interesting critique on the role of richer countries in exploiting the developing world when it comes to the rules of global trade.

To conclude then, David Smith certainly appears to be an advocate of the free market and laissez-faire capitalism, something for which he has received a little criticism of late. However, his views are only natural I suppose, especially given his position as economics editor at the Sunday Times. Nevertheless, he presents the opposing viewpoints in a neutral and non-condescending manner, with all relevant views given the consideration they deserve.

Whilst some of his criticism of Marxist theories is valid, in an additional ‘Appetizer’ added to the new edition of the book he covers the current financial crisis without really tackling the problems inherent with an under-regulated financial services market. Perhaps as this section was authored in October 2008, whilst the crisis was still unfolding, we can give him the benefit of the doubt but as a recent editorial in the Independent makes clear, the problems inherent within capitalism must be tackled if we are to prevent the bubble bursting yet again:

The costs to the public of a laissez-faire attitude to markets from the state manifest themselves in excessive charges and needlessly high prices. But the public costs by no means stop there. The reason Britain has one of the biggest deficits in the G20 is because the Treasury became so heavily reliant on the bubble revenues of an inadequately regulated financial services sector. Britain is facing years of savage public spending cuts largely because of the failure of successive ministers and regulators to curb the recklessness of the banks.
The Independent – Editorial  (23 September 2010)

I decided to write to David Smith at the Sunday Times, to put these minor criticisms to him myself, but also to praise him on a job well done. He very kindly sent me the following response:

Dear Mr Davis,

Thank you for sending me the copy of your review, which is very fair. One small point. Though it is commonly believed that the causes of Britain’s sharp swing into enormous budget deficit was a collapse in City tax revenues, as in The Independent editorial, the causes are rather more complex than that. As this paper demonstrates – the tax take from the City has dropped but not collapsed. The recent better-than-expected revenues from the Labour government’s windfall tax on bank bonuses demonstrate that.

The deficit was caused by a more general drop in tax revenues, particularly income tax, National Insurance and VAT, together with a recession-related rise in public expenditure and the fact that a previous planned slowdown in spending was deferred until after the crisis. The banks were indeed reckless and should have been better regulated though as we have seen this problem was not confined to the UK.

That is just a minor point. As I say, your review is very fair.

Best wishes, David Smith

– Email from David Smith  (2nd October 2010)

I’m now beginning to develop an impression of the economy as a huge balancing act, with economists constantly being confronted with new problems to solve, which I believe is what makes economics so exciting and books such as this so important. Despite some small faults, Free Lunch is a fantastic, jargon-free introduction to economic theory, and I would highly recommend it to anybody who like me, would previously have flicked past the ‘boring’ business pages of their daily newspaper.