Original pub: 11/21/2015 (2.0 11/22/2015)
It might surprise the reader to learn that modern economic theory is literally set in the Stone Age. This is the direct result of mainstream analysis constructed on what amounts to barter. Of course, one may not immediately find this admission in a standard textbook, because more palpable terms such as supply-and-demand or “Real Analysis” are used to cloak the fact that money is an afterthought. In fact, money in a world of barter is simply another item to barter for (i.e. chicken eggs can be money in such a world). And just like cavemen who worshiped the gods of rain and thunder, sophisticated general equilibrium analysis has its own set of fantasies in the form of goods literally falling like manna from heaven and invisible auctioneers to call out millions of prices across the nation in order to clear the “free market” (make sure the good sells through price adjustments). Since this obviously would raise the eyebrows of the skeptical student an extra measure layer of complexity is wrapped around the subject matter in the form of the Quantity Theory of Money, completing the bed-time story known as “pure exchange”.
The chances are good you won’t hear of manna and heaven in your Economics 101 class, but there is a small chance you will probably hear the sanitized version in terms of “endowments of goods” if you go out on your own to dig a little deeper. This is similar to the idea of buying a new house where the generous previous owner has left you a new SUV in the garage as a gift and the presumption that you will sell it at half of the production cost because you already have a car you are happy with. This is a bit more subtle than it appears, because it subconsciously softens the student of modern economics to the idea that the labor content (industrial cost of production) is no longer relevant to the price formation of the good. This isn’t your great granddad’s economics anymore, nor Adam Smith’s, David Ricardo’s and Karl Marx’s to be precise. Nor was it convoluted enough to make it text book worthy. What was overlooked we are told was the amazing sophistication of caveman exchanges. Little did we realize marginal productivity and marginal utility with advanced calculus and simultaneous equations requiring super computers were buried in deer skin and arrow trading.
But why stop there? When one of the founders of the Austrian School of economics (the intellectual home of many modern libertarians with an interest in economic theory) Carl Menger argued it makes no difference to the price of a diamond should we have simply found it lying on the street or require a million dollars worth of earth moving machinery, he had taken supply-and-demand logic to new heights of subjectivism. In other words, Menger was arguing that the theory of supply-and-demand based pricing hadn’t gone far enough: Only demand mattered in price formation of a good. What uber subjectivists are trying to tells us is that the factory accountant is not sophisticated enough to understand the deeply hidden nuances of his own pricing process. In other words, if the public got together and demanded a new car only cost $100 dollars an astonishing process of wage “imputation” would take place. Eventually all workers salaries would collapse to a penny an hour so that all 14,000 parts making up an the final product would amount to $100. So not only did the industrialists, bankers, economists, and merchants of 1800s fail to grasp the power of marginalist magic, they apparently had the causality of wage formation backwards!
Because bad fruit leads to more bad fruit, models of pure exchange also have a set of very bitter tasting offspring in the form of so called capital theory, business cycle theory, and growth theory. These are contentious debates among different schools of economic thought that touch on saving, investment, machines, over investment, natural and market interest rates, time preferences, marginal efficiency of capital, marginal products, and rates of returns. Even with the introduction of credit (which you think would knock some sense into the discussion), most schools of thought must resort to keeping the properties of a commodity at the foundation of the discussion, because barter principles would have to be abandoned without it. This results in such an amazing mess of ideas that I have yet to find a straight forward introductory text suitable for the beginner or myself (if you know of one, point me in that direction).
It is perhaps worth digressing and asking what exactly makes it such a mess. In layman’s terms, it is the result of a merciless 100 plus year effort to hammer a round supply-and-demand peg into a square labor theory of value (traditional cost of production) hole. In textbook theory terms, it is the result of a fictitious construct called factors of production: 1) land, 2) labor, and 3) capital (machines). If you’re wondering why the entrepreneur is not listed as a contributor to production here, well, the best I can come up with is to the escape the wrath of the Marxist, not to mention it makes things a lot easier to make messy and problematic profits vanish in modern models. But I digress. In the world of so called neoclassical Real Analysis, whose goal is to determine the relative prices (two apples equate to one orange), we must first begin with non-monetary units of measure of our factors of productions: 1) an acre of land, 2) an hour of labor, 3) and a –oh, oh– a unit of something of capital. No worries, we’ll just keep hammering on that round peg until we manage to convince ourselves of the idea that capital must generate the equivalent of a worker’s wage in the form of interest or profit or some sort of rate of return. At that point we are confident that a chain saw amounts to a perpetual bond generating interest forever (no joke). How this would actually work in practice with a tree service company consisting of axe men upgrading to chain saws is completely beyond my grasp, because the company owner does not buy chain saws with the expectation of an associated return to the chain saw (i.e. calculated interest rate); he buys it to stay in business in terms of price competitiveness (it’s about survival, not income estimations). To make matters worse, neoclassical economics preaches the men using the new chainsaws must be ambidextrous so as to be able to use a chain saw in each hand where we may or may not find the marginal point of productivity of capital due to diminishing returns. And do not forget, the price of the chain saw is the result of its rate of return (imputation is back). If that is really the case, can someone please show me how a chain saw that costs $200 to produce has a rate of return to the owner? I’m all ears.
As a result such outer worldly thinking, I have decided to confine my focus on saving (thrift) and investment (factory machinery) as a possible linchpin to take down capital and growth theory. Let’s start with a typical Robinson Crusoe model that might help us illustrate barter-o-nomics perception of saving’s (i.e. reduced consumption’s) relation to investment. Imagine you are living alone on an island fishing by spear and struggling to stay alive. As a result, your daily catch is near subsistence. Then one day out of desperation you perceive of making a net. Note the dilemma which arises. You will have to give up spear fishing for a few days to make a net. In terms of mainstream thinking, you will have to save by consuming less in order to invest in making a capital good in form of a net. Your thrift is directly proportional to your invested time in your net making. Your typical macro textbook will take this idea to a grand scale: National Saving = National Investment. Then it follows (within calculus derived limits), the more you save, the more capital goods (nets) you can create and the more prosperous you will be (never mind that our the industrial base is fleeing to China as a result of these theories–just play along for now). So thrift is necessary virtue. Or is it?
Notice in this simple model there was no money, no credit, no bank. Let’s make the model a bit more sophisticated. Let’s assume 100 people are stranded and have organized into fishing industries, net-making industries, and banking (which is nothing more than book keeping, risk assessment, and insurance in the form of an interest premium to cover default risks). Let’s now give this an interesting twist to challenge the gold-bugs (Austrian School). Let’s assume there is no gold or silver on the island so commodity money cannot be used for exchange. As essentially modeled in our previous discussion (“Just Measures”), the banker will simply do nothing more then assess the credit worthiness of the applicant and then issue credit out of thin air. Also critical to the new island economy is the establishment of a minimum wage as an arbitrary scale which serves as the unit of account for credit creation and wages.
With the fundamentals in place for a functional industrial economy, we will now examine if a relationship between saving and investment is still needed. The banker issues credit to the fishing company to pay wages and buy nets. He also issues credit to the net makers for tools, wages, and raw materials (so called circulating capital) needed for net production. The cost of nets and interest are recovered as part of the cost of production of catching fish (simple mark up). Thus all parties can consume their share of fish. Note there is no thrift in the traditional sense in this scenario. No one has to stop eating fish to make a net.
Let’s take a step further to examine a growth scenario in order to see if it undermines my logic. Assume a genius at the net making company comes up with an idea for a net that costs half the price to make and catches 5 times the fish, enough fish to put half the fishermen out of work (you can only eat so many fish in a day). To make the next round of nets, he would only require half the employees and half the credit. Such a scenario I suspect spells doomsday for capital theory which preaches the notion of “more capital” as the road to “more prosperity” (how to measure capital is another story for another day). In our model, we have just demonstrated that less capital results in more wealth (higher output, higher standard of living).
But how can unemployment mean more wealth? Simple. This is short term unemployment that frees up workers to now move into the coconut harvesting industry. Though a slight over simplification, the consumer savings in the fish market are freed up for the luxury of coconut purchases. As a result, in no time the economy returns to full employment at a higher level of prosperity (no longer does the GDP consist of just fish, it is now fish and coconuts richer–notice the dollar value of GDP does not change even though they are richer).
But let’s try to be good sport and give the modern capital theorist a model perhaps more to his liking with “more” investment. Let’s assume a new super net requires a net investment (pun intended). In other words, the new net technology requires an increase of labor over the old net production process to make it (net company has to hire more workers). This may seem like a step backwards, but the critical assumption is that for every 5 new net workers 20 fishermen will lose there job. The total labor content in fish is reduced, otherwise the nets would never sell.
Again for this scenario, increased credit would be created out of thin air (no savings required). But we now have a problem in that this is a closed economy. Where is the labor to come from? The net maker has to hire fisherman away the fishing industry. Here we seem to be at risk of admitting defeat to the saving=investment (S=I) theorists, since in a roundabout way, we will have to catch less fish (fishermen diverted to net making). Could the so called Swedish School ultimately be right in their perception of forced savings in the form of less fish on the market having to bid up wages to hire away or keep fishermen as investment in the net industry expands requiring more labor? This is the million dollar question.
So how can we save our model? Let’s expand the realism of the model to include many industrial sectors, each which are increasing productivity at a steady pace and thus reducing labor content of their output. In such a world, there will always be short term unemployment due to a steady pace of productivity gains. As argued in “Just Measures” economic growth built on a labor theory of value and a necessarily rigid wage structures (anathema to mainstream thought) makes such unemployment inevitable (turning economic theory on its head). Therefore, I do not feel it is a stretch to assume these workers can be moved to a capital sectors which are growing in terms of needed labor without any real impact on the wage rate. In simple terms, the unemployed fisherman become the net makers in the long run.
The S=I myth goes back to ideas of the classical school when gold was king. But even then, businessmen used their own IOUs to circumvent the bankers and limited gold stocks. The consequences of this line of thought ripple through nearly all schools of economics: For example, the traditional Keynesian notion of government intervention to stimulate investment in order to compensate for perceived “unstable” investment behavior of industry (Keynesians treated consumer saving as stable–the reverse of any recession I’ve lived through). If there is no relation between S and I, the entire intellectual edifice becomes a moot point. Adjustments based on interest rates are irrelevant. Even if we give the Keynesians the benefit of the doubt, the core logic is unfortunately still deficient in my view. It is the consumers who pull back on spending in a highly complex way which drive recessions. One individual may buy less books, while another abstains from movies for example. Since a nation’s investment level is determined by 200 years of industrial advancements, there is no room for government driven investment in the private sector to make up for 150 million unique shifts in consumption behavior. For example, the automotive sector is minimized already in terms of needed labor due to the state of the art of technology. If buyers abstain from car purchases, government cannot undo the technology structure willy nilly by investing in it so to speak. Government can of course build a few new roads and bridges, but depending on the magnitude of a recession, this amounts to a drop in the bucket and a lot of wishful thinking. The flip side of the S=I coin is the neoclassical view that interest rates and infinitely and instantly flexible prices/wages will restore the S=I gap which has opened up in a recession. But has I have attempt to show here, S=I is myth to begin with. Again the model falls.
The goal of this essay has been to develop a new line of debate in the arena of economic theory, because as I have argued before, there has never been a sound theory of economics and America’s decline is the inevitable result. As always, critique, corrections, and new interpretations are always welcome.