No such thing as a free lunch

Here comes another joke about economists. Suppose you just have found a tenner on the street. You are very excited about your windfall and tell the next person you meet about your find. You say, ‘I just found a tenner on the street.’ Now, this individual happens to be an economist. And he replies, ‘That is impossible. If there really was a tenner on the street, someone would have picked it up already.’

Economists also say, ‘There is no such thing as a free lunch.’ Some people get a free lunch, but someone else has to pay for it. If you find a tenner, someone else paid for it. If there is money for free, people will take it and let others pay for it. Economists call it arbitrage. It is also what trade is about. Traders try to make money by finding money for free, but in doing so, they work and take risks.

Economics assumes humans are rational in economic matters and do not leave tenners on the street. We make the best of our money by choosing the right products. And we make as much as we can with our abilities. If we get cash for free, many would not work or only do jobs they like to do. And even though we often are not rational, it explains much of our behaviour, most notably what happens in markets. If there is a tenner on the street, it will not be there for long.

If gold costs € 50 per gramme in France and € 40 in Germany, traders can make money by buying gold in Germany and selling it in France. The demand for gold in Germany will rise, as will the supply in France. The law of supply and demand says that the price goes up when demand increases and goes down when supply increases, so the price in Germany and France will be the same.

Economists call it arbitrage. Smuggling comes from the same principle. Cigarettes are more expensive in the United Kingdom than on the European continent. You can make money smuggling cigarettes into the United Kingdom and selling them there illegally. The price difference promotes smuggling. The difference between arbitrage and smuggling is that arbitrage is legal.

Markets without morals

Even though most individuals have moral values, markets do not have them. There are always people willing to market a harmful product. Their excuse often is that if they do not, someone else will. Laws can illicit smuggling and black markets. It helps if laws and enforcement are the same everywhere. Still, supply always equals demand at a specific price. So, if you outlaw harmful substances or practices, say alcohol, prostitution, cocaine, gambling, or cigarettes, you promote crime and violence because criminals make more money.

And so, the War on Drugs is a failure, like the prohibition in the United States in the 1920s. If selling cocaine is legal, the price difference between Colombia and the United States would be close to the production and transport costs. In that case, a gramme of cocaine might cost $ 5 in Colombia and $ 6 in the United States. But if it is illegal, and governments enforce the law, a gramme of cocaine might cost $ 10 n Colombia and $ 100 in the United States, and criminals make lots of money in the trade.

As crime-related violence engulfs more and more countries, gangs of criminals undermine governments and societies by giving poor people an income, bribing officials and hiring hitmen to eliminate those who stand in their way. Seeing it as an economic problem might help to find solutions, for instance, undermining the criminal business model by letting governments supply harmful substances and gambling and regulating prostitution. If governments keep repressing the drug trade, they make the criminal enterprise unprofitable by bringing their cost above the price for which governments sell.

It brings moral dilemmas, but unlike criminals, governments do not do marketing, for instance, by giving drugs to children to turn them into addicts. Governments have no profit motive, which allows governments to help drug addicts and give them treatments. But this does not stop the fentanyl crisis in the United States. This drug is too cheap and too deadly. Only unconventional measures like taking all the addicts off the streets and locking them up might end the suffering. To solve this issue, we might need to be as committed as the Taliban and accept the human cost. The human cost will be higher if we are lax. If an addict dies because of these measures, this person would have died anyway, and the gain is in the people we save.

Trust but verify

Similar issues arise when governments tax, punish criminals, give subsidies or provide social benefits. If that elicits the desired behaviour, that is good, but that does not always happen. Businesses shift their profits to tax havens. Wealthy individuals do the same with their assets. If there are social benefits, people who do not like to work or dislike their job try to get on the dole. Many people need those benefits, but fraud undermines their legitimacy.

Reasonable people are willing to pay taxes for people who need help but not for fraudsters. Tax and welfare fraud may get understated or overstated for political reasons. If you can commit fraud and gain financially, some will do it. And if they get away with it, more will do it. That undermines trust. Regulations need enforcement. For instance, not enforcing building regulations allows contractors to make money using inferior materials. And that happens with devastating consequences.

When private contractors perform public tasks, and the government pays for them, there is an opportunity for fraud. In the Netherlands, the government decentralised several forms of social work to the municipalities. Since then, criminals and fraudsters have set up businesses in those areas. The choice is either for governments to do these tasks themselves or to work with reliable suppliers by vetting them, perhaps even licencing them, and monitoring their performance.

Trade as finding tenners

Trade is like looking for tenners on the street and keeping them, even if you know the previous owner. You might call it pickpocketing. The difference is not always clear. Hermes, the Greek god who was the protector of the merchants, was also the refuge of the thieves. Popular culture views traders with suspicion. Value is subjective. If you bought an item for € 50 but could have bought it elsewhere for € 40, did the seller dupe you, was the item worth € 50, or were you stupid?

And we cannot do without trade. Few people have the time to go to all the producers for the things they need, nor have these producers the time to handle each individual that needs their product. If you had looked around, you might have found the same item for sale for € 40, but perhaps, you were too busy and happy to get the item instantly without looking around. Trade performs the following functions:

• Goods are made in one place and used somewhere else. Trade bridges distance.
• Goods are produced first and consumed later. Trade bridges time.
• Goods usually are made in large batches and used in smaller ones. Trade matches volumes.

Crucial to trade is information. A trader must know what is on offer for what price and where, and for what price it might sell when and where. Gathering that information costs time and effort. If you trade potatoes, you buy them in large quantities from farmers during the harvest and sell them in smaller quantities to greengrocers throughout the year. You must offer an attractive price to the farmers and the greengrocers. Otherwise, they will go elsewhere. And your business must make a profit. Otherwise, you might as well have stayed in bed to watch television.

Financial markets

A tenner dwells more likely on streets where others do not look. Wall Street firms hire the brightest minds on the planet to find these places. For instance, Apple stock may be for sale for € 150 in Australia while it is doing € 151 in Germany. If you want to pick up that euro, you must be there and act quicker than everyone else. Wall Street firms thus invest in the fastest computers and networks.

So if a tenner falls out of your pocket on the stock market, Wall Street firms have already picked it up before it hits the street. They may soon apply artificial intelligence to look inside your pocket and fetch the tenner before it falls. So if you are willing to sell your stock for € 150 and someone else is willing to pay € 151, Wall Street banks may snatch the securities you offer for € 150 and sell it to the other for € 151.

If the interest rate in one country is lower than in another, you can profit by borrowing money in the first country and lending it out in the other. It can be attractive to borrow yen at 1% to buy dollars to lend them at 5% and pocket the difference. Economists call this a carry trade. You might expect that, like the price of gold, interest rates would converge because the yen interest rate would rise because of the borrowing in yen, while the dollar interest rate would fall because of the lending in dollars.

That did not happen. The central bank sets the interest rate and can create money. The Japanese central bank kept lending yen at 1% and buying dollars because the Japanese government did not like the yen to rise. That could hurt their exports. If the US central bank held the interest rate at 5%, and the Japanese central bank prevented the yen from rising, that meant lots of free money for banks. The Japanese paid for it. They could have bought more with their money if it had been worth more.

One of the most troubling issues with trade, markets and capitalism, is that value is subjective and often depends on irrational emotions. The market value of an empty Gucci bag is higher than that of a shopping bag filled with potatoes. And even though we cannot establish objective value, we need food more than designer bags. The appreciation of subjective value is what makes the current economic system suicidal. A happy shopper today can be a dead one tomorrow.

Lately, I found a tenner on the street. Economists can be wrong. Well, indeed.

Latest revision: 19 August 2023

Featured image: A tenner on the street. Free Shutterstock image from Blackday.