SUPPLEMENT X:
NEO-CLASSICAL ECONOMIC THEORY:
A FANTASY ON REALITY.
(2014)
PAUL S. SIDLE.
ALFRED KORZYBSKI'S (1924) “ANTHROPOMETER” (STRUCTURAL DIFFERENTIAL).
FROM “GENERAL SEMANTICS BULLETIN NUMBERS 69-70”
EDITOR-IN-CHIEF JAMES D. FRENCH (2003).
SUPPLEMENT X:
NEO-CLASSICAL ECONOMIC THEORY: A FANTASY ON REALITY
(2014)
PAUL S. SIDLE.
Neo-classical Economic Theory principally arose with the works of William
Stanley Jevons (1835-82), Léon Walras (1824-1910), Carl Menger (1840-1921; apart
of the Austrian school of Economics with amongst others Friedrich August Von
Hayek, 1899-1992), along with Alfred Marshall (1842-1924), as counter-revolution
to the work of John Maynard Keynes (1883–1946), whom himself tried to improve
upon the Classical Theory, principally founded by Adam Smith (1723-90), David
Ricardo (1772-1823), Karl Heinrich Marx (1818-83), moreover I would include
Aristotle (380-322 B.C.), etc.
The Neo-classical Economic theory based their limited mathematical
framework upon a number of unfounded assumptions:
(1). 'Innate' value.
(2). Optimal Equilibriums:
(a). Treats a dynamic system as a 'static' one, building models
rooted in the 'concept' of equilibrium instead of non-equilibrium
'analysis' (though using 'elementalistic' two-values, etc., still
wrong).
(b). Demand intersects supply.
(c). Supply 0, when Demand 0, thence price 0.
(3). Law of Demand: ('always') demand falls when price rises.
(4). Reductionism: Macro-economics can become reduced to Micro-economics.
(5). 'Static' models, from point 2a):
(a). Disregards dynamic processes as different-complex from 'statics'.
(b). Ignores 'time', in terms of change, from point 5a).
(c). Predicts from given initial conditions as 'always the same' (as
knowable), contrary to Chaos-and-Complexity Theory.
(6). 'Linear' mathematics:
(a). Ignores non-linear mathematics.
(b). From point 5c)., disregards unpredictable changes given from small
differences in initial conditions: "Butterfly Effect" (after Edward
Norton Lorenz (1979)): large scale events changes unpredictably
because of sensitive dependence on initial conditions – small
'causes' leads to large unpredictable 'effects'.
(7). Uncertainty from 6b)., transformed as knowable risk.
(8). 'Perfect' system, as Steve Keen (2011) writes: "...in which the market
ensures that 'everything is just right'. It is a world in which
meritocracy rules, rather than power and privilege as under previous
social systems. This vision of a society operating perfectly without a
central despotic authority is seductive – so seductive that neoclassical
economists want it to be true".
(9). Economic foundation in the Philosophy involving 'Utilitarianism', after
Jeremy Bentham (1748-1832), 1861:
(a). Pleasure-Pain Principle: any Human 'behavior' represents the product
of 'innate' drives to pleasure-seek-and-avoid-pain.
(b). People motivated by self-interest.
(c). Principle of Utility:
(i). Whereupon the interests of the community, therefore simply
involves the 'sum' of the interests of the individuals who
comprise it. As Bentham states:
"The community is a fictitious body, composed of the individual
persons who are considered as constituting as it were its
members. The interests of the community then is, what/- the
sum of the interests of the several members who compose it. It
is in vain to talk of the interest of the community, without
understanding what is in the interest of the individual".
(ii). Thus economic market represented by the interests of a single
individual, epithet by Prime-Minister Margaret Thatcher (1980s):
"There is no such thing as society".
(iii). Measurement of utility (util), as Bentham writes: "An action
then may be said to be conformable to the principle of utility
(10).
(11).
(12).
(13).
(14).
when the tendency it has to augment the happiness of the
community is greater than any it has to diminish it".
(iv). Law of Diminishing Marginal Utility: states that "the marginal
utility (change in total utility), is always positive, but
always falling: more is always better, but each additional unit
consumed gives less satisfaction than previous units".
Monetary Theory (Great Moderation):
(a). Inflation regulated by Central Banks, via interest rates:
(i). 'Controls' incomes independently of prices.
(ii). Full-employment possible, since a factor of low inflation.
(iii). Housing prices a factor of inflation.
(iv). 'Controls' loan interest rates, e.g., cash-rate.
(v). Etc.
(b). Money Multiplier model: "Quantitative Easing" (printing money), in
order to buy up debts.
'Rationality' of consumer, whereupon each consumer will maximize their
choices, product of Game Theory, in particular the work of John Forbes
Nash Jr., (1950, etc).
Social-and-progressive: maximizing social welfare. Where economists have
tried to prove the assumption of Adam Smith's metaphor (given by Keen,
2011): "a self-motivated individual is led by an 'invisible hand' to
promote society's welfare asserts that self-centered behavior by
individuals necessarily leads to the highest possible level of welfare for
society as a whole".
Modeling without debt: debt a very important variable, was not considered
leading up to the Financial Crisis, 2007-10 (despite 10b).
Science based on inconsequence of assumptions, but upon their utility in
prediction, after Milton Friedman (1953); methodology upon Philosophy
advanced by John Dewey's (1938), Instrumentalism.
The Neo-Classical Counter Revolution:
In the 1960s, inflation, which had remained as low as 1%, began to rise in a
series of cycles to a peak of 15% in 1980; unemployment, which had in past had
gone down when inflation went up, began to rise aswell in the 1970s; both in
contradiction to Keynesian doctrine.
Consequently, the more informed media, made the climate right for change,
supporting the efforts of leading neo-classical economists such as Milton
Friedman (1912-2006), in order to overthrow the Keynesian old-guard in halls of
education. Economic public policy then shifted focus from the Keynesian
emphasis upon keeping unemployment low, while tolerating higher inflation as a
side-effect, as asserted by John Maynard Keynes, 1st Baron Keynes; to keeping
inflation low, in the belief that this would allow the private sector to
function-and-achieve full employment.
The rising Neo-classical economists, though at best perhaps confused,
remained optimistic for their theory to work, since for them the consequences
Neo-classical policy appeared clear. Inflation plunged the United States
Federal Reserve Bank (US Fed) Chairman Paul Adolph Volcker (1927-, American
economist-and-banker, Chairman of the board of governors of the Federal Reserve
System, 1979–87), to push the cash-rate (rate of interest on loans to commercial
banks) to 20%. Yet unemployment exploded to a post-war peak of nearly 11% in
1983; though in the next successive recessions, unemployment in the early 1990s
only reached a peak of 8%, while that in 2003, a peak rate of 6.3%. However,
inflation had come down, fluctuating in a range between 1-4%, with occasional
spikes of 6%, but importantly far below the tumultuous period 1965-85, whereupon
the average appeared around 6%. Thus Neo-classical economists enshrined the
objective of keeping inflation low in the rules they set for Central Banks,
which instructed them to manipulate the rate of interest to keep inflation in a
narrow range between 1-3%. US Fed., Chairman Ben S. Bernanke (2004), wrote
asserting that in the last 2 decades of achievement:
"...not only significant improvements in economic and productivity but
also a marked reduction in economic volatility, both in the United States and
abroad, a phenomenon that has been dubbed “the Great Moderation”.
Recessions have become less frequent and milder, and quarter-to-quarter
volatility in output and employment has declined significantly as well.
The sources of the Great Moderation remain somewhat controversial, but I
have argued elsewhere, there is evidence for the view that improved control of
inflation has contributed in important measure to this welcome change in the
economy".
So when in 2007, the Great Moderation came to an abrupt end, with the beginning
of the worst Global depression seen since the 1929 Crash, the neo-classical
economists reeled in shock. Since suddenly 'everything' which the neo-classical
economists said that could not happen, happened 'all' at once: asset markets
went in free-fall, centuries old bastions of economic finance like that of
Lehman Brothers went bankrupt, etc., while the defining features of the Great
Moderation evaporated: unemployment streaked higher than before, while a mild
inflation gave way to deflation.
Here let us remind ourselves that the 2007-10 Financial Crisis had
occurred due to the confidence of the market evaporating when the enormous
borrowing-and-risk speculation upon it became duplicitously transparent like a
great "Ponzi Scheme" (named after after Charles Ponzi; Ponzi Scheme represents a
fraudulent investment operation that pays returns to separate investors from
their own money, otherwise money paid by subsequent investors, rather than from
any actual profit earned) discovered. The whole structure derived from a public
sector investment-and-borrowing, made possible by assets brought by Chinese
investment in US., bonds, with which the banks only seemed too eager to risk
speculating, made especially incoherent since the original loans given by banks,
got re-packaged as risk-speculations re-sold to other investors and-or banks.
Suddenly Neo-classical doctrine got replaced by Keynesian economics,
having eschewed government intervention for a free-market system free of
regulation, budget deficits, whilst a boosting of government-created money for
decades, etc., whereupon instead at their bidding, instead the governments
nationalized. Budget deficits hit levels that dwarfed anything that the oldfashioned Keynesians had ever run in the 1950-60s, while government deleveraged
in order to buy debts, flooding the economies like Niagara Falls. Bernanke US.
Fed., Chairman, literally doubled the level of "Quantitative Easing" (printing
money: government-created money) in the US economy in 5 months, whence the
previous doubling had taken some 13 years; such that a long decay in the ratio
of government-created money to the level of economic activity, from 15% of GDP
in 1945 to a low of 5% in 1980, while 6% when the crisis began, was eliminated
in less than a year as Bernanke's Quantitative Easing, saw the ratio rocket back
to 15% by 2010.
In this Money Multiplier model, money gets created in a two-stage
process:
(1). The government creates fiat money, say by printing dollar bills, then gives
them to an individual. The individual then deposits the dollar bills in
their bank account.
(2). The bank keeps a fraction of the deposit as a reserve, then lends the rest
out to a borrower. That borrower then deposits this loaned money in
another bank account.
This process then repeats.
Let us say that the government creates $100, of which a fraction of 10%, the
banks keep known as the Reserve Requirement (set by the government, else by the
Central Bank); while it takes banks a week to go from getting a new deposit to
making a loan. With this process, which starts with the government creating
$100, carries on 1 week later with the first bank creating $90 by lending 90% of
that money to a borrower; a week later, the second bank creates another $81, by
keeping $9 of the new deposit in reserve, while lending out the other $81; etc.,
so that, after many weeks, this creates $1,000, consisting of the initial
printing of $100 by the government, while $900 in credit money created by the
banking system, which gets matched by $900 in further debt; consequently,
allocates $900 of credit money in circulation, facilitating trade, while another
$100 of cash held in reserve by the banks.
Now in this simple example, the actual bank notes remain in the banks'
vaults, while 'all' commerce gets undertaken by people electronically
transferring the amounts in their deposit accounts. Ofcourse people will keep
some notes in our pockets aswell as for small transactions, so there remains
less credit than the example actually implies, but the model can become modified
to take this into account.
This process of printing money (Quantitative Easing), moreover has become
known as Fractional Reserve Banking, which US., President Barack Obama, on the
advice of his neo-classical economists, relied upon to rapidly bring the recent
Financial Crisis (which Keen refers to as the Great Recession) to an end.
Figure 1.
The volume of Bank Money in Ben Bernanke's Quantitative Easing in historical
perspective.
From Steve Keen (2011) "Debunking Economics".
Week
Loans
0
1
2
3
4
5
6
7
8
9
10
Total After 10 Weeks
Final Totals
0
90
81
73
66
59
53
48
43
39
35
686.19
1,000
Deposits
Cash Kept
By Banks
Sum Of
Loans
100
90
81
73
66
59
53
48
43
39
35
586.19
900
10
9
8
7
7
6
5
5
4
4
3
68.62
100
0
90
171
244
310
369
422
470
513
551
586
586.19
900
Sum Of
Cash
10
19
27
34
41
47
52
57
61
65
69
68.62
100
Table 1.
The alleged Money Multiplier Process ($).
From Steve Keen (2011) "Debunking Economics".
Consequently however, attempts to use the Money Multiplier as a
'control' mechanism, to restrict credit growth as during the Monetarist period
of the late 1970s, otherwise to create a boom in the lending during the recent
Financial Crisis, are bound to fail. Printing money is not a 'control'
mechanism at 'all', but a simple measure of the ratio between the private
banking system's creation of credit money, with the government's creation of
fiat money. This can vary dramatically over 'time': growing when the private
banks expand credit rapidly, while the government tries, largely vainly, to
restrain the growth in money; collapsing when private banks-and-borrowers
retreat from debt in a financial crisis, while the government tries, again,
largely vainly, to drive the rate of growth of money up. This involves
something that Bernanke should have known from his own research on the Great
Depression which began in with the Wall Street Crash of 1929. Whence, the Money
Multiplier rose from under 6 in the early 1920s to over 9 in the 1930s, only to
plunge to below 4.5 by 1940.
Figure 2.
The empirical Money Multiplier 1920-40.
From Steve Keen (2011) "Debunking Economics".
Yet perhaps Bernanke did remember this lesson from history, since his
increase in base money involved a far greater amount than his predecessors.
Bernanke may have put such a massive influx of money into the system simply
because he feared that little-or-no additional credit money would be forthcoming
as-a-result; such that, better to flood the economy with fiat money, with the
hope that alone it would create the desired boost to aggregate demand.
Some 'multiplier effect', President Obama, was ill-advised by his neoclassical economists; the huge injection of the fiat money would have become far
more effective had it gone instead to the public, who at least might have spent
it into circulation; which Obama had actually first seriously considered. Since
in the recent Financial Crisis, Bernanke's intervention resulted in the injected
money driving up the unused reserves of the banking sector as never before (from
$20 billion before the crisis to over $1 trillion after it), while the Money
Multiplier, which in actuality are no more than the ratios of the 3 measures of
the broad money-supply, M3, M2, M1, to the base money, collapsed as never before.
The M3 ratio fell from over 16 to under 8, which has moreover continued to fall
to below 7 since; the M2 ratio, the ratio most comparable to M1 ratio back in the
1920-1940s, fell from 9 to below 4, while most embarrassingly, the M1 ratio fell
below 1, hit as low as 0.78, while still remained below 0.9 two years after
Bernanke's fiat money injection.
Though some neo-classical economists know that the 'Money Multiplier'
does not work, admitting that it does not 'exist' is inconvenient because, if
so, then the supply of money is not exogenous, set by the government, but
endogenous, as determined by the workings of the market economy. This in turn
entails that this endogenous process affects 'real' economic variables such as
the level of investment, the level of employment, moreover the level of output,
when it has 'always' been a tenet of Neo-classical theory that "money doesn't
matter". Therefore in acknowledging the obvious empirical fact that the 'Money
Multiplier' is a myth, further entails letting go of another favorite neoclassical myth, that the dynamics of money can safely be ignored in economic
'analysis'.
Henry Mencken's aphorism, as given by Keen (2011): "Explanations exist;
they have existed for all time; there is always a well-known solution to every
human problem – neat, plausible, and wrong". Seems not only appropriate for
Money Multipliers, but for Neo-classical economics as-a-whole.
Yet while the economists ran panicked, accusations flew around, but no
one would ofcourse take any of the blame, which led to the question why had no
one seen this coming? Ah, how wonderful a denial entrenched in multiplicity?
The Organization for Economic Cooperation and Development's (OECD),
"Small Global Forecasting" model, which makes predictions for the global
economy, which then become disaggregated to generate predictions for individual
countries, instead leading up to the crisis had seemed benign. Though this OECD
model includes monetary-and-financial variables, these are not taken from data,
but instead derived from theoretical assumptions about the relationship between
'real' variables, such as the "gap between actual output and potential output",
with that of financial variables. As Dirk J. Bezemer (2009) noted, the OECD's
model lacks any of the features that dominated the economy in the lead-up to the
crisis: "There are no credit flows, asset prices or increasing net worth driving
a borrowing boom, nor interest payment indicating growing debt burdens, and no
balance sheet stock and flow variables that would reflect all this".
The neo-classical economists believed that they could ignore the
financial system in economic 'analysis' (though consequently proved by the
depression as crucial to the understanding of the economic system), since they
argued that the 'real' exchanges went on behind a "veil of money"; moreover they
assumed that the 'real' economy functioned as in the metaphor, "like a miracle
engine that always returns to a state of steady growth, never generating any
undesirable side-effects". Neo-classical 'faith' emerges from the seductive
nature of the vision it portrays of 'Capitalism', as a 'perfect' system, in
which the market ensures that 'everything is just right'; a world where
meritocracy rules, without a central despotic 'authority', rather than powerand-privilege as under previous social systems. However, neo-classical
economists in their ignoring of the how a market economy functions, moreover
their deliberate failure to monitor the dynamics of private debt, led to their
inability to see the crisis coming; hence the last ones to work out how to end
it! Consequently, far from becoming the bastion of economic wisdom, Neoclassical economics became the biggest impediment to understanding how the
economy functioned, hence moreover allowed if not created, the periodic
breakdowns!
Neo-Classical Assumptions:
Utility Of Pleasure-Pain:
The originator of the premise that "people are motivated solely by selfinterest" is not Adam Smith, but his contemporary Jeremy Bentham. Bentham's
(1761) Philosophy "Utilitarianism", which he called the Philosophy of the
"Principle of Utility", which sought to explain human 'behavior' in terms of the
product of 'innate' drives to seek pleasure, while avoiding pain; with which he
applied to the community aswell as to the individual:
"The community is a fictitious body, composed of the individual
persons who are considered as constituting as it were its members. The
interests of the community is, what? – the sum of the interests of the several
members who compose it. It is in vain to talk of the interest of the community,
without understanding what is in the interest of the individual".
Bentham consequently became confident that individual pleasure-and-pain could
become 'objectively' measured, in turn 'summed' to divine the best course of
collective 'action' (in terms of punishments to discourage) for that collection
of individuals called society. Bentham's statement that "The community is a
fictitious body...The interests of the community is...the sum of the interests
of the several members who compose it" is no more than an assertion.
Nevertheless, economists have come to use Bentham's model to explain
'everything' from individual 'behavior' to market demand, to the representation
of the interests of the entire community. However, in order to turn Bentham's
assertion into a theory, economists had to achieve 2 tasks: to express Bentham
mathematically, but especially to establish mathematically that it becomes
possible to derive social utility by aggregating individual utility.
Economists' early attempts to use Utility theory to explain 'behavior', resulted
in them postulating "utils", as the underlying units of satisfaction when
consuming any commodity; whereupon further units of a given commodity resulted
in a smaller number of 'utils', reflecting a drop in the satisfaction given by
subsequent consumption of further units of a commodity. For example, as given
in Table 2., by Keen.
Bananas
1
2
3
4
Utils
8
15
19
20
Change in utils
8
7
4
1
Table 2.
'Utils' and change in units from consuming bananas.
From Steve Keen (2011) "Debunking Economics".
However Jevons, one of the co-founders of Neo-classical economics
remained justly sceptical about reducing 'all' human 'behavior' to formulae.
Moreover, how the use of the above 'utils', can in any way become justified as
other than a 'subjective' treatment of a 'subjective' process; since what an
individual derives from a commodity must depend on a number of factors,
including, hunger, preferences (whether the individual even likes bananas), to
store, etc.
Law Of Demand:
The Law of Demand thus restricted by neo-classical economists, to a single
individual, whereupon when utility rises more gets consumed; but another
assumption taken here involves the 'rationality' of the consumer to optimise
(maximize) their choices. The Demand Curve (demand for a particular commodity)
generated involves the relevant commodity placed on the horizontal axis, any
other commodities on the vertical, while the budget constraint ignored. The
resulting curve known as the "Engel Curve", represents an increase in income
with relative prices held 'constant', showing a consumer maximizing their
utility as their income rises.
Whereupon the shapes show how demand for a particular commodity changes as a
function of income, but there involves 3 kinds of commodities, since neutral
goods do not exist:
(1). Necessary-goods: which diminishes as income increases, e.g., toilet paper,
though you may buy more expensive paper.
(2). Giffen-goods: low quality goods, whose actual consumption declines as
income declines, e.g., baked beans, which may entirely disappear.
(3). Luxury-goods: where consumption rises as income rises, e.g., holidays.
(4). Neutral-goods: homothetic goods, where their consumption remains 'constant'
in proportion of income as income rises.
Finally the Market Demand Curve gets generated from 'summing' the individual
demand curves.
Economists maintained that there appeared 2 conditions which guaranteed
the Law of demand applied to the market demand curve:
(1). That 'all' Engel Curves represent 'straight' lines.
(2). That 'all' Engel Curves of 'all' consumers represent 'parallel' lines to
each other.
However, the first condition entailed that 'all' commodities have neither to be
luxuries, necessities, nor Giffen-goods, but 'neutral-or-homothetic'; therefore
the ratios of the consumption of different goods must remain fixed regardless of
income, clearly non-sense since as income rises an individuals' consumption
pattern would change. Therefore, this entails that condition 1)., holds true
for only 1 commodity; whilst condition 2)., becomes absurd, since for 'all'
consumers to have 'parallel' Engel Curves, 'all' of these consumers must have
'identical' tastes. Non-sense since individual implies 1 of many different
consumers, recognized by their different tastes; hence both conditions imply 1
consumer, 1 commodity. Thus the Law of demand will only apply if, and only if,
relates to only 1 commodity, with 1 consumer. Such that since the Law of
demand's purpose, involves explaining how relative prices become set, then will
make no sense, if this law applies only to 1 commodity, consumed by only 1
consumer.
This leaves us with a further contradiction, that the Law of demand
cannot relate to the market demand curve, since now instead of the market demand
curve increases when price falls (even if individual demand does), the 'sum' of
these tendencies, the market demand curve, will thus occasionally show demand
rising as price falls, but moreover it may occasionally show demand falling as
price falls, since increasing price will favour the producer (thus increasing
their demand); whereas the rising income for the luxury-goods producer, will
increase their income, while decreasing that of the necessity-goods producer.
This result has become known as the Sonnenschein-Mantel-Debreu (SMD) condition,
after H.F. Sonnenschein (1972), R.R. Mantel (1974), G. Debreu (1974), which
proves that the Law of demand cannot apply to the market demand curve.
Consequently, a demand curve can assume any shape, which entails that there can
occur 2-or-more possible demand levels for any given price, even if 'all
consumers are rational' utility maximizers who individually obey the Law of
demand.
Moreover, when Reinhard Stippel (1997) attempted to test the "Axioms of
Revealed Preference", developed by Paul Samuelson (1938), as a way to derive a
theory of consumer 'behavior' in which utility did not need to be explicitly
considered, it incidentally allowed the testing of the theory of Utility
Maximizing 'Behavior'.
Samuelson defined a 'rational consumer' on the basis of how that consumer
would 'behave' when confronted with choices between bundles of goods; whereupon
he derived 4 rules to distinguish 'rational' (here the supposed distinction
whereby an individual 'behaves' to maximize their choices, in consuming goods,
self-interests, avoiding pain in the seeking of pleasure, etc) 'behavior' from
'irrational':
(1). Completeness: that a 'rational' consumer could compare different bundles of
commodities, thence decide which bundle preferred. If in comparing 2
bundles, then this involved 3 possible outcomes, when given 2 bundles A,B:
(a). Preferred A, to B.
(b). Preferred B, to A.
(c). Indifferent between A, B.
(2). Transitivity: if combination A, preferred to B, while B, to C, then A,
becomes preferred to C.
(3). Non-Satiation: entails that more 'always' preferred to less, thus if B, has
an extra something to A, then B, gets preferred to A.
(4). Convexity: represents a mathematical expression of the 'concept' of
Diminishing Marginal Utility; arguing that if A, B, represent very
different bundles, then the 'linear' combination of the bundles' contents
of both should become preferred. Suppose that we have shopping
trolleys A, B, where A, contains 10 chocolate bars, while B, contains 10
packs of chips, then 10 other shopping trolleys could become constructed by
swapping 1 chocolate bar with 1 pack of chips, each of which would become
more desirable than the trolleys A, B.
Whereby the Marginal Utility a consumer gets from each commodity falls with
further units, so that Indifference Curves (compared demand curves for an
individual) represent a convex shape, as Keen puts it, "shaped like a
'slippery dip'".
Whereupon Stippel found that if obeying these rules makes one 'rational', then
the vast majority of us are irrational. Though Stippel probably did not conduct
his experiments other than to derive Indifference Curves, for each of his
subjects, whereby confirming that economic theory accurately describe
'behavior'. However, Stippel found that his subjects were not maximizing their
their utility as economic theory required of them.
To each of his subjects,
Stippel gave an income, from which they can choose from a specified lists of
goods, refer to Table 3.
The problem, as Keen argues, involves one of dimensionality (curse of);
Stippel had given his subjects a choice between 8 commodities, asking them to
make their preferences according to their limited income; as Stippel observed:
"A closer look at the actual demand data corrobrates the view that the
subjects did not choose randomly. Every subject showed a marked preference for
some of the goods while other goods were not chosen at all, even at low prices.
Some subject's demand was quite price inelastic, whereas others substituted
cheaper goods for their more expensive counterparts, e.g. Coke for orange juice,
sometimes to the extent that they always switched from one to the other,
depending upon which was cheaper in the particular situation. There can be no
doubt that the subjects tried to select a combination of goods that came as
close as possible to what they really liked to consume given the respective
budget constraints".
Goods
Video clips
Computer games
Magazines
Coca-Cola
Orange juice
Coffee
Candy
Pretzels, peanuts
Max. amount (if 'all' budget spent on one good)
30-60 minutes
27.5-60 minutes
30-60 minutes
400ml-2 litres
400ml-2 litres
600ml-2 litres
400g-2 kilos
600g-2 kilos
Table 3.
The Commodities in Reinhard Stippel's (1997) "Revealed Preference" experiment.
Taken from Steve Keen's (2001) "Debunking Economics", modified.
However, despite this intention to choose the best option, they failed to
do so 'rationally' according to Samuelson's rules. Why, well, between 8
different commodities, the subjects could choose any amount of them that they
could afford, which means in actuality, the subjects could choose an infinite
number of combinations. Now, the Neo-classical definition of 'rationality'
requires that, when confronted with this amount of choice, the consumer's
choices remain consistent 'every' 'time'; but the real irrationality lies in
expecting that that any sentient individual can make the number of comparisons
required to choose the optimal combination given a finite 'time'.
A new idea to Science?, no, this commonplace observation has become
noticed in Computer Science since Alan Mathison Turing (1912-54; British
mathematician, logician, who had made contributions to many Sciences), who in
1936, described an "'Universal' Computing Machine" that could theoretically
become programmed to solve any problem capable of solution; with the exception
of 2 conditions, known as the Laws of Computational Theory:
(1). You cannot compute nearly 'all' the things you want to compute
(Turing, 1936).
(2). The things you can compute are too expensive to compute
(D.H. Ballard, 2000).
The first law reflects Turing's research, which established that most 'logical'
problems cannot be solved by a computer program. The second asserts that for
the majority of problems that can become solved, the Curse of Dimensionality,
entails that an optimum solution cannot be found in finite 'time', no matter how
much computing power gets directed to it.
The discovery should have become revolutionary, since intersecting
demand-and-supply curves would have to give way to a more complicated but
necessarily more 'realistic' theory, in which prices would not be in
equilibrium, whereby the distribution of income would alter as prices alter.
Classical economists, as represented by Smith, Ricardo, Marx, etc., had
divided society into 'classes' whereupon they considered how different policies
might favor one social 'class' over another. Yet the Indifference Curve which
replaced it cannot be meaningfully aggregated, since the 'concept' is invalid
for the 'analysis' of anything more than an isolated individual. However, it is
not reasonable to lump 'all' workers, landlords, capitalists, etc., since
'class' incomes vary less than compared between 'classes', while preferences
(tastes) more likely shared within 'classes', than between them. However, neoclassical economists, 'concept' of utility remains highly 'subjective', whereas
that the price system actually determines income distribution is false. Since,
a change in relative prices will change the distribution of income, it therefore
changes who consumes what, hence the 'sum' of the subjective utility of 'all'
individuals; whereby if utility 'subjective', then there is no way to determine
whether one distribution of income generates more-or-less aggregate utility than
any other. Economists originally used this argument against social reformers,
who wished to redistribute income from the rich to the poor; arguing that such a
redistribution might actually reduce social welfare by taking a unit of a
commodity from a rich person who derived a great deal of utility out of it,
Supply
Price
P
Demand
Q
Quantity of Commodity
Figure 3.
Demand Curve related to Supply Curve as comparison between Price with Quantity.
Point of intersection P,Q = equilibrium.
The Standard supply-and-demand explanation for price determination is valid only
in 'Perfect Competition'.
Figure 4.
A Valid Demand Curve.
From Steve Keen (2011) "Debunking Economics".
thence giving it to a poor person who derived very little utility from it.
Nevertheless, it appears ironic that the defense of inequality ultimately
backfires on economics, by making it impossible to construct a market demand
curve which is independent of the distribution of income; if the market demand
curve depends upon the distribution of income, if a change in prices will alter
the distribution of income, further if this does not result in a single
equilibrium between Marginal Revenue (the change in revenue that producers get
from selling an extra unit), along with Marginal Cost (the cost of producing the
last unit), then economics cannot defend any one distribution of income over any
other. A redistribution of income that favors the poor over the rich cannot be
formally opposed by economic theory, instead economic theory requires such a
redistribution before it can even derive a market demand curve.
Mainstream economists (19th-century) asserted that there could be no
"general gut": while individual markets might have more supply than demand, in
the aggregate other markets had to occur where there involved more demand than
supply. Therefore, while there could be problems in individual markets, the
entire economy should 'always' remain in balance, because a deficiency in one
market would get matched by an excess in another. 'All' that would become
required to correct the imbalance would involve letting the market mechanism
work, so that the price of the good with excess demand would rise while the one
with excess supply would fall.
With demand neo-classical economists had to prove that one can aggregate
individual demand curves to coincide with the original versions of Utility
theory, in order to justify the redistribution of wealth. In order to avoid
that conclusion, economists had to show that altering the distribution of income
did not alter social welfare; whereupon worked out 2 conditions remained
necessary:
(a). 'All' people have the 'same' tastes.
(b). Each person's tastes remain the 'same' as their income changes.
So that 'every' additional dollar of income spent, should become exactly the
'same' way as 'all' previous dollars. The former assumption in fact amounts to
assuming that there remains only one person in society; the latter assumption
amounts to assuming that there involves only one commodity; since otherwise
spending patterns would necessary change as income rose, whereby the net effect
involves that one fundamental building block of the economic 'analysis' of
markets, the demand curve, does not have the characteristics needed for economic
theory to be internally consistent. Important because neo-classical economists
tried to prove that a market economy necessarily maximizes social welfare; if
they cannot prove that the market demand curve falls smoothly as price rises,
they cannot prove that the market maximizes social welfare. Moreover, the
'concept' of a "Social Indifference Curve" appears crucial to many of the key
notions of neo-classical economics: the argument that free-trade necessarily
superior to regulated trade.
The Standard Model of the labor market asserts that wages should appear
highly unlikely to reflect workers' contributions to production; because neoclassical economists treat labor as no different from other commodities; with
the assumption of an upward sloping Supply Curve (supply of a particular
commodity) taken as the normal situation. Whereupon neo-classical economists in
using the Standard Model, try to justify drawing very strong conclusions:
arguments against minimum wages, trade unions, demand management by government
(need for benevolent redistributors of wealth), etc. However, workers will not
get a fair wage when they face organized-or-very-powerful employers unless they
themselves organize into unions. Labor is not produced for profit, moreover the
supply curve for labor can 'slope backward', so that a fall in wages can result
in an increase in the supply of workers; hence fails to prove that employment
becomes determined by supply-and-demand, while confirms the 'real' world
observation that involuntary unemployment can occur, as reducing the wage need
not bring the demand-and-supply of labor into alignment.
Neo-classical theories of the stock-market, has a basis in the "Efficient
Market Hypothesis", which show how it assumes that 'everyone is identical' in
terms of what they know, what they can get, what they do with knowledge-andcash, etc.; this results in a theory which argues that investors can correctly
predict the future. Neo-classical economists therefore argued for the
deregulation of the finance-markets, while as many funds as possible invested in
them. While the theory may benefit the minority of share holders who own the
bulk of shares, whilst help them pressurize government policy, it is hard to see
how it benefits the rest of society.
Keen (2011) focuses on Hyman Minsky's (1977) "Financial Instability
Hypothesis", along with Irving Fisher's (1933) "Debt-Deflation", as a
consequence for depression, especially our current Global Economic Crisis.
Their combined 'hypothesis' predicts that an overly large debt related to GDP
ratio can cause deflation-and-depression; where, the falling of the price level
results in a continually rising 'real' 'quantity' of outstanding debt.
Moreover, the continued deleveraging of outstanding debts increases the rate of
deflation. Thus, debt-and-deflation interacts resulting in a debt-deflation
spiral, the consequence a depression.
The Statics Of Dynamics:
A. Statics: Absence Of Space-Time:
One of the fundamental weaknesses of conventional economics, involves the
absence of the flow of 'time' in their 'analysis'; a problem Neo-classical
economics bases itself, which involves as-a-result, on taking a snapshot of
'time'. Therefore, somewhat ironic that those neo-classical theorists argue
that in the defense of their theory, they appeal to the importance of 'time';
however, far from helping to defend economic theory from criticism, the proper
'analysis' of 'time' instead highlights a critical weakness.
For example, Neo-classical principles for the Rational Firm, which argues
that profit becomes maximized where marginal cost equals marginal revenue, yet
this is only correct if the quantity produced never changes. Thus when we
combine this with the assumption that an individual consumption curve (demand
curve) formulates to the whole community by 'summation' of such individuals
having the 'same' tastes, etc., (market demand curve) led to a very distorted
'stasis' of the economic system function. By not allowing for differential
changes, however small, when then 'summed up', the resultant view of the economy
involves one of 'stability'-and-'sameness', just the sort of view expected by a
'perfect' system when functioning. This homogeneous functioning of the economic
market, moreover assumed an inability of the producers to expand, whereupon any
further demand on the producer must inevitably lead to more costs.
The demand curve represents the rate of change of the total benefit,
while the supply curve represents the rate of change of total cost; as according
to the Neo-classical interpretation as discussed. Therefore the benefit to
society gets maximized where these 2 rates of change, one rising, the other
falling, become equal. Producers try to maximize the benefit to them, their
profits, not society's benefits; where these 2 interests, consumers aiming to
get the maximum benefit out of consumption, while producers trying to get the
maximum profit out of production, only coincide if the price equals marginal
revenue; since the price, the amount that consumers become willing to pay, tells
the producer the marginal utility that they get from the last item consumed.
Only if this furthermore equals the marginal revenue that the producer gets form
selling this very last unit of output will the benefit to society moreover equal
the individual gain for the producer who sells it. This can only occur if the
marginal revenue for producing this last item equals the price.
Only 'perfect' competition can guarantee this outcome, since economists
believe only then does marginal revenue 'always' equal price. 'Perfect'
competition ('perfect'), because a supply curve 'exists if, and only if', price
equals marginal cost.
A firm's revenue-and-costs clearly vary over 'time', aswell as varying as
the firm changes their level of output at any point in 'time'. The economic law
that (in the context of diminishing returns) "profit is maximized where marginal
cost equals marginal revenue" gets derived by holding time constant", thus
describing revenue-and-cost as simply a function of the quantity produced. The
gap between revenue-and-cost gets widest where marginal cost equals marginal
revenue. However, in fact this law applies "when time stands still", which
'time' never does. Similarly, the law tells us how to maximize profit with
respect to quantity, but actual businessmen remain more interested in maximizing
profit over both 'time'-and-output.
It becomes possible to consider profit as a function of both 'time'-and'quantity', as opposed to the economic approach of dividing 'time' into
artificial segments, by explicitly acknowledging that profit becomes a function
of both 'time-and-quantity' (which the firm can vary at any point in 'time',
such that will moreover change, while hopefully grow with 'time'); though
ignores the issue of ecologically sustainability: assumes that resources will
never exhaust. Profit therefore depends both on the amount a firm produces,
along with the historical 'time' during which it produces.
Using a law from mathematics, we can then decompose the change in profit
into the contribution due to the progress of 'time', with the contribution due
to changes in quantity (which moreover will change over 'time'); this then
results in the formula: "Change in profit equals change in profit due to change
in time multiplied by the change in time, plus change in profit due to change in
quantity multiplied by the change in quantity". The formula tells us how big a
change in profit will occur, so if a firm wants to maximize their profits, it
wants this number to become as large as possible; where this change in profit
due to change in quantity = marginal revenue - marginal cost. Instead Neoclassical theory argues that profit becomes maximized when marginal revenue =
marginal cost (an established fallacy), but if one followed the Neo-classical
Profit Maximization Law here, then this quantity would become deliberately set
to 0. Since one gets 0 when we x (times) any number by 0, following this law
sets the second half of the formula (change to profit due to change in quantity
x by the change in quantity) to 0; this the consequence of Neo-classical theory
ignoring 'time'.
B. Dynamics Of Statics:
A problem not considered seriously by economists, involves that within
evolutionary systems, effectively 'everything' can change. Instead economists
have become wedded to the notion of ceteris paribus ("all other things remaining
equal") as a way of remaining able to impose some order on the apparent chaos of
the market. Ceteris paribus involves ofcourse an illusion, but the illusion
often seems preferable to 'reality' when it appears that fully acknowledging
'reality' forces one to abandon structure; which again is not true.
For the founding fathers 'static' 'analysis' merely represented a stopgap measure, a transitional methodology which would become superseded by the
dynamic 'analysis'. Jevons (1886), for example, argued: "If we wished to have a
complete solution we should have to treat it as a problem of dynamics". But
instead Jevons (1888) pioneered 'static' 'analysis': "it would surely be absurd
to attempt the more difficult question when the more easy one is yet so
imperfectly within our power".
Similarly Marshall (1890): "The Mecca of the economist lies in economic
biology rather than in economic dynamics. But biological conceptions are more
complex than those of mechanics; a volume on Foundations must therefore give a
relatively large place to mechanical analogies; and frequent use is made of the
term 'equilibrium', which suggests something of statistical analogy. This fact,
combined with the predominant attention paid in the present volume to the normal
conditions of life in the modern age, has suggested the notion that its central
idea is 'statistical', rather than 'dynamical'. But in fact it is concerned
throughout with the forces that cause movement: and its key-note is that of
dynamics, rather than statics".
However, by the end of the 19th-century, J.B. Clark (1898), the economist
who developed the Marginal Productivity Theory of Income Distribution (amount
produced by the last worker), looked forward to the 20th-century as the period
during which economic dynamics would supplant economic 'statics':
"A point on which opinions differ is the capacity of the pure theory
of Political Economy for progress. There seems to be a growing impression that,
as a mere statement of principles, this science will fairly soon be complete.
It is with this view that I take issue. The great coming development of
economic theory is to take place, I venture to assert, through the statement and
solutions of dynamic problems".
Clark gave many fine reasons why economics should become 'analyzed' using
dynamic rather than 'statics'; foremost among these that: "A static state is
imaginary. All actual societies are dynamic; and those that we have principally
to study are highly so. Heroically theoretical is the study that creates, in
the imagination, a static society".
One century later economic dynamics has indeed become developed but not
by the school with which Clarks belonged. However, Neo-classical economics
still ignores the issue of 'time', as given by Keen: "Students are often told
that dynamics is important, but they are taught nothing but statics. A typical
undergraduate macroeconomics textbook (which Keen quotes from, "Taslim and
Chowdhury, 1995"), for example, states that “the examination of the process of
moving from one equilibrium to another is important and is known as dynamic
analysis”. However, it then continues that “Throughout this book we will assume
that the economic system is stable and most of the analysis will be conducted in
the comparative static model”".
As Keen then continues to argue: "We also live in a changing – and normally
growing – economy. Surely we should be concerned, not with absolute levels of
variables, but with their rates of change? Should not demand and supply
analysis, for instance, be in terms of the rate of change of demand, and the
rate of change of supply? Should not the outcome of supply and demand analysis
be the rate of change of price and quantity over time, rather than static
levels? Should not macroeconomics concern itself with the rate of change of
output and employment, rather than their absolute levels?
Of course they should. As Keynes also once remarked, “equilibrium is
blither”. So why, fifty years after Keynes, are economists still blithering?".
In reply to his own questions Keen then states: "There are many reasons, but the
main one,...is the extent to which the core ideological beliefs of neoclassical
economics are bound up in the concept of equilibrium. As a by-product of this,
economists are driven to maintain the concept of equilibrium in all manner of
topics where dynamic, non-equilibrium analysis would not only be more relevant,
but frankly would even be easier".
'Perfect Competition' Prevents Monopolies (Equating Marginal Cost With Marginal
Revenue As Profit-Maximizing 'Bahavior'):
Neo-classical theory predicts that industry output will converge to the
competitive 'perfection' as the number of firms in the industry rises. The
market outcome is not caused by collusion, but simply the result of profitmaximizing 'behavior'. Firms further follow very different paths in their
output, even though the basic strategy remains very similar for each firm: vary
output, to try to find the output level that generates the largest profit.
Firms have very different outcomes with respect to profit aswell, though in
general most make for more profit from a trial-and-error (thus heuistic)
approach, than if they had followed the Neo-classical formula. Many different
outcomes appear possible from different assumptions, but the Neo-classical
premise that a strictly 'rational' 'behavior' leads to a competitive industry
producing where individual marginal revenue equals marginal cost is strictly
false.
Neo-classical theory asserts that the profit a firm will involve the
revenue, which will equal the firm's output x the market price – (minus) costs.
Thus what we must then do, involves working out how these 2 aspects of profit
become influenced by the changes in output by 'all' the firms in the industry,
including the firm we remain in interest of.
Using the "Product Rule" (a
calculus method), the change in the revenue side of the calculation can become
reduced to:
(1). Output x how much a given firm's change in output changes market price.
(2). Market price x how much a given firm's change in output causes the firm of
interest to alter output.
From George J. Stigler's (1957) calculus, we can substitute the slope of the
market demand curve for "how much a given firm's change in output changes market
price", so the first term in the change of revenue calculation becomes the
firm's output x the slope of the market demand curve. With 1,000 firms in the
industry, we get 1,000 copies of the term, which equates to your firm's
interested output x by the slope of the market demand curve.
The second term in the change in revenue involves the market price x the
amount that your firm's of interest output changes owing to a change in output
by a given firm. Since working with the Marshallian model, which assumes that
firms do not 'react' strategically to what other firms do, then 999 times out of
1,000 this term will involve the market price x 0. But at least once, it will
involve how much the firm of interest output changes, given a change in the
firm's output. The ratio of the change in the firm's output to the change in
the firm's output, = 1, so once-and-only-once, the calculation will return the
market price.
Finally, we must consider the cost side of the calculation: how much the
firm's total costs change, given a change in output by a given firm. As with
the last calculation for revenue, 999 times out of 1,000 this will = 0, since
the firm's of interest costs do not change when the output of another firm
changes. But once-and-only-once, it will equal how much the firm's total costs
change, given a change in the firm of interest change in output; this then
equals the firm's marginal cost. Now this gives us 3 terms:
(1). Market price (Mp, a positive number);
(2). + (plus) the slope of the market demand curve (DCM) x by 1,000 x your firm
of interest's output (O, a negative number, because of the negative slope
of the market demand curve);
(3). – the firm of interest's marginal cost (Mc).
Whence, the output level which the firm chooses causes the 'sum' of these 3
terms to 0, you have 'identified' the output level at which the firm of your
interest will maximize their profits.
Where the Neo-classical formula tells us that the firm will maximize
profits when these 3 terms equal:
(1). The market price (Mp);
(2). + the slope of the market demand curve (DCM) x by your firm of interest's
Output (O);
(3). - the firm of interest's marginal cost (Mc).
Mp + DCM x 1000 x O - Mc = Mp + DCM x O - Mc
Equation 1.
Whereas, the Neo-classical formula omitts the 999 x your firm of interest's
output x the slope of the market demand curve, a very large negative value.
Therefore, the whole Neo-classical formula takes a larger marginal cost to
reduce 0, which it can only achieve by producing a higher output; which since
must be sold at a loss: the increase in revenue the firm will get from selling
those further units will be less than the increase in costs the extra production
causes.
Thus the Neo-classical formula is wrong about the level of output by the
individual firm that maximizes their profits, except in the one situation of a
monopoly, where the 2 formulae coincide. Hence, the result of any competition
in the long-run, forms to drive prices down to the disadvantage of small
businesses; whilst in favour of monopolies formed from large companies, with
surplus revenue.
There occur other theories of competition, for example, those of CournotNash (after Antoine-Augustin Cournot (1801-77); John Forbes Nash, Jr., (1928-))
Cournot-Bertrand models of game-theory 'behavior', where firms 'react'
strategically to what other firms might do, in which a 'perfectly competitive'
outcome can occur from non-profit-maximizing 'behavior'. For example, Keen
(2010), asserts that "the Cournot and Bertrand theories both erroneously argue
that the level that maximizes firms' profits is identified by the firms behaving
collusively, like a pseudo-monopoly. Instead Keen and Standish (2010),...show
that the so-called collusive output level is simply the level the firm would
produce if they behaved as simple profit maximizers".
The Neo-classical theory of production argues that capacity constraints
play a key role in determining prices, with the cost of production, therefore
prices, rising as producers try to squeeze more-and-more output out of a fixed
number of machines, in what they call "the short run": a period of 'time' long
enough to change variable inputs, such as labor, but not long enough to change
fixed inputs, like machines, otherwise for new entrants into the industry.
The argument has several stages:
(1). Stage 1: that productivity falls as output rises.
Neo-classical theory asserts that the supply curve slopes upward because
productivity falls as output rises; this falling productivity translates
into rising price, thus a direct link between marginal productivity, with
marginal cost.
(2). Stage 2: which rephrases the declining productivity argument as rising
costs.
(3). Stage 3: determines the point of maximum profitability for 'identifying'
where the gap between revenue-and-costs seems greatest.
Keen presents an in-depth example of neo-classical 'thinking' involving the
above (refer to Table 4):
"This mythical firm has fixed costs of $250,000, and pays its workers
a wage of $1,000. It can sell as many units as it can produce at the market
price of $4. To produce output at all, the firm must hire workers: with no
workers, output is zero. The first worker enables the firm to produce 52 units
of output. This is shown in the first row of the table: the labor input is one
unit, and total output is 52 units.
The marginal product of this worker – the difference between production
without him – is 52 units. The marginal cost of the output is the worker's wage
- $1,000 – divided by the number of units produced – 52 – which yields a
marginal cost of $19.20.
The average fixed costs of output at this point are enormous - $250,000
divided by just 52, or $4,807 per unit. The average total cost is $251,000
divided by 52, or $4,827 per unit – which implies a loss of $4,823 per unit
sold, if this were the chosen level of production.
At this stage, production benefits from economies of scale. Just one
worker had to perform all tasks, whereas a second worker allows them to divide
up the jobs between them, so that each specializes to at least that extent.
With specialization, the productivity of both workers rises. The same process
continues with the ninth and tenth workers, so that the marginal product of the
ninth – the amount he adds to output over and above the amount produced by eight
workers – is 83.6 units. Similarly, the marginal product of the tenth worker is
87.5 units.
If the firm actually produced this number of units, it would lose
$127,207 dollars – more than its fixed costs. However, the process of rising
marginal productivity – and therefore falling marginal cost – comes to the
rescue as output costs. By the tenth worker, the firm is still making a loss,
but the loss is falling because its marginal cost has fallen below the sale
price. The 100th worker adds 398.5 units to output, at a marginal cost of
$1,000 divided by 398.5, or just $2.50 a unit. This is less than the sale price
of $4 a unit, so the firm is making a profit on the increase in output – but
only enough to reduce its losses at this stage, rather than to put it into the
black.
Quantity
1
2
3
10
11
2,001
2,002
4,001
6,001
8,001
10,001
12,001
14,001
16,001
18,001
20,001
Fixed Cost
Total Cost
Marginal Cost
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,015
1,000,030
1,000,045
1,000,150
1,000,165
1,022,419
1,022,428
1,042,433
1,086,464
1,190,514
1,400,190
1,770,696
2,366,836
3,263,017
4,543,241
6,300,100
15.00
15.00
14.99
14.96
14.95
8.80
8.80
13.41
33.62
74.23
140.05
235.86
366.48
536.70
751.32
1,015.01
Table 4.
Costs for a 'hypothetical' monopoly.
From Steve Keen (2011) "Debunking Economics".
Black ink arrives with the 277th worker, who brings in $3,090 profit –
the proceeds of selling the 772.5 additional units the worker produces at the
sale price of $4 a unit – for the cost of his wage of $1,000.
This process of rising marginal productivity continues right up to the
400th worker hired. By this stage, marginal cost has fallen dramatically. The
400th worker adds 850 units to output, so that the marginal cost of his output
is the wage of $1,000 divided by 850, or $1.18 (rounded up to $1.2 in the
table). Average fixed costs, which were enormous at a tiny level of output, are
relatively trivial at the output level of 233,333 units: they are down to just
over a dollar.
From this point on, productivity of each new worker ceases to rise. Each
new worker adds less to the output than his predecessor. The rationale for this
Table 5.
Input, Output Data for a 'hypothetical' Firm.
From Steve Keen (2011) "Debunking Economics".
is that the ratio of workers – the 'variable factor of production' – to
machinery – the 'fixed factor of production' – has exceeded some optimal level.
Now each extra worker still adds output, but a diminishing rate. In economic
parlance, we have reached the region where diminishing marginal productivity
applies. Since marginal product is now falling, marginal cost will start to
rise.
But profit continues to rise, because though each additional worker adds
less output and therefore brings in less revenue, the revenue from the
additional units still exceeds the cost of hiring the worker. In economic
parlance, marginal revenue exceeds marginal cost.
We can see this with the 500th worker, who adds 800.5 units to output.
The marginal cost of his output is the wage ($1,000) divided by 800.5, or $1.25
(rounded down to the table). This is higher than the minimum level of $1.18
reached with the 500th worker. But the additional units this worker produces
can all be sold at $4, so the firm still makes a profit out of employing the
500th worker.
The same principle still applies for the 600th worker, and the 700th.
Productivity has dropped sharply now, so that this worker adds only 401.5 units
to output, for a marginal cost of $2.50. But this is still less than the amount
the additional output can be sold for, so the firm makes a profit out of this
worker.
This process of rising profit comes to an end with the 747th worker,
whose additional product – 249.7 units – can only be sold for $998.8, versus the
cost of his wage of $1,000. From this point on, any additional workers cost
more to employ than the amount of additional output they produce can be sold
for.
The firm should therefore employ 746 workers, and maximize its profit at
4837,588. At this point, the marginal cost of production equals the marginal
revenue from sale, and profit is maximized.
The 800th adds 52 units, for a now soaring marginal cost of $19.20. By
the time we get to the 812th worker, workers are – metaphorically speaking falling over each other on the factory floor, and this worker adds a mere 3.3
units to output, for a marginal cost of $300. The next worker actually reduces
output".
Keen's exposition above, simply describes the situation faced by one firm. In
order to derive the Market Supply Curve, we have to aggregate the supply curves
of a multitude of producers, just as to complete the derivation of the market
demand curve, from the demand curves of a multitude of consumers. Since each
individual firm's Marginal Cost Curve appears upward sloping, the market supply
curve must moreover upward slope.
Piero Sraffa (1926) however, first pointed out that this argument is
flawed, whose critique involved the "Law of Diminishing Marginal Returns", which
determines anything in the economic theory of production: the output function
determines marginal product, which in turn determines marginal cost. With
Diminishing Marginal Productivity, the marginal cost of production eventually
rises to equal marginal revenue. Such that where firms seek to maximize profit,
while since this equality of (rising) marginal cost to marginal revenue gives
you maximum profit, then this determines the level of output.
Sraffa's argument thus focused upon the Neo-classical assumptions that
there occur Factors of Production which remained fixed in the short-run,
whereupon supply-and-demand remained independent of each other, which he
considered as false, since they could not be fulfilled at the 'same' 'time'. If
instead 'constant' returns appear the norm, then the output function instead
involves a 'straight' line through the origin, just like the total revenue line
should, though showing a different slope. So is as the factory owner hopes, the
slope of revenue becomes greater than the slope of the cost curve, then after a
firm had met their fixed costs, it should go on to make a profit from any
subsequent unit sold: the more units it sells, the greater the profit achieved.
Thus in terms of the model for 'perfect competition', there should be no limit
to the amount a competitive firm would wish to produce, such that Neo-classical
theory could not explain how firms (in a competitive industry) decided how much
to produce. In fact according to the Classical model each firm should wish to
want to produce an infinite amount, in order to attain an infinite amount of
profit.
In those circumstances where some factors of production, did appear fixed
in the short-run, supply-and-demand would not be independent, so that each point
of the supply curve would relate to a different demand curve. However, in
circumstances where supply-and-demand could justifiably become treated as
independent, then in general it would be impossible for any factors of
production to be fixed. Hence the marginal costs of production would become
'constant'.
Sraffa began however, by noticing that preceding Classical school of
economics had had a Law of diminishing marginal returns too; however, it
involved no part in price theory, but comprised part of the theory of income
distribution; with an application largely for the explanation of rent.
Classical economists had argued that the best land available would get farmed
first, only afterwards when this land had become fully utilized would land of a
lesser quality get used. Thus, as population grew, progressively poorer land
would become brought into use. This poorer land would produce a lower yield per
acre, than the better land. Diminishing marginal returns therefore applied, but
they occurred because the quality of the land used fell, not because of any
relationship between fixed-or-variable factors of production.
Sraffa thus argued that the Neo-classical theory of Diminishing
Marginal Productivity had a mis-founded basis in their use in their model of a
competitive economy, where the model assumed that 'all' firms were so small
relative to the market that they could not influence the price for their
commodity, while factors of production remains homogeneous. Thus in the Neoclassical model, falling quality of input could not explain diminishing marginal
productivity; instead productivity could only fall because the ratio of variable
Factors of Production to fixed factors exceeded some optimal level.
The question then arises when-and-if it becomes valid to regard a given
factor of production say, land as fixed. Sraffa suggested that only in the
broadest possible definition that say an industry like agriculture can become
valid as to treat factors it uses heavily (such as land) as fixed; since further
land can only become obtained by converting land from other uses (manufacturing,
tourism, etc), it is clearly difficult to increase that factor in the short-run.
Thus the agriculture industry will suffer diminishing returns as predicted.
However, with such a broadly defined industry, any changes in their
output must affect other industries, such that any attempt to increase output
will affect the price of the chief variable input, labor, as it takes workers
away from other industries; moreover this will affect the price of the 'fixed'
input. This might appear to strengthen the case for diminishing returns, since
inputs become more expensive aswell as less productive. However, it undermines
2 other crucial parts of the model:
(1). Premise that demand-and-supply of a commodity remains independent.
(2). Premise that one market can become studied in isolation from 'all' other
markets.
Instead, if increasing the supply of agriculture changes the relative prices of
land-and-labor, then it will further result in the change in the distribution of
income. Since changing the distribution of income changes the demand curve,
hence there will appear a different demand curve for each different position
along the curve for agriculture; which will make it impossible to draw
independent demand-and-supply curves that intersect in just one place. As
Sraffa (1926) asserted:
"If in the production of a particular commodity a considerable part of
a factor is employed, the total amount of which is fixed or can be increased
only at a more than proportional cost, a small increase in the production of
the commodity will necessitate a more intense utilization of that factor, and
this will affect in the same manner the cost of the commodity in question and th
cost of the other commodities into the production of which that factor enters;
and since commodities into the production of which a common special factor
enters are frequently, to a certain extent, substitute for one another the
modification in their price will not be without appreciable effects upon demand
in the industry concerned".
Sraffa's next argument though leaves the demand curve intact, undermines
the 'concept' of a rising supply curve. Since, Sraffa asserts that if we use a
more 'realistic' narrow definition of an industry, say one of wheat rather than
agriculture, in general then, diminishing returns are unlikely to occur, because
the assumption that supply-and-demand remain independent now appears reasonable,
while the assumption that some factor of production is fixed is not.
While Neo-classical theory assumes that production occurs in a period of
'time' during which it is impossible to vary one factor of production, Sraffa
argues that firms-and-industries in the 'real' world, will have the ability to
vary 'all' factors of production fairly easily, because these 'additional'
inputs can become taken from other industries, or-both taken from stocks of
under-utilized resources. For example, if there occurs a increased demand for
wheat, then rather than farming a given quantity of land more intensively,
farmers will instead convert some land from another crop, say barley, to instead
cultivate wheat, else they will convert some of their own land currently lying
fallow to wheat production, otherwise other farmers who currently grow a
different crop will convert to wheat. A factory, unlike the expectations of
neo-classical theorists, do not construct their facilities under-resourced-orsufficient to capacity, but build a surplus capacity into the facility in case
of the requirement for expansion of existing production, otherwise for other
production needs. As Sraffa expressed it:
"If we next take an industry which employs only a small part of the
'constant factor' (which appears more appropriate for the study of the
particular equilibrium of a single industry), we find that a (small) increase in
its production is generally met much more by drawing 'marginal doses' of the
constant factor from other industries than by intensifying its own utilization
of it; thus the increase in cost will be practically negligible".
This entails that, rather than the ratio of variable to 'fixed' outputs
rising as the level of output rises, 'all' inputs will become variable, the
ratio of one input to another will remain 'constant', where productivity will
remain 'constant' as output rises; which results in 'constant' costs as output
rises, which means a 'constant' level of productivity. Sraffa here considers
that output will therefore represent a 'linear' function of the inputs: increase
inputs by 20%, where output will accordingly rise the 'same' amount. Since the
shapes of the total, average, along with marginal cost curves entirely entail
the product of the shape of the output curve, a 'straight'-line output curve
results in 'constant' marginal cost, aswell as falling average costs.
With this cost structure, the main problem facing the firm involves
reaching a break-even point, where the difference between the sale price,
compared with the 'constant' variable costs of production just equal their fixed
costs; from that point on sales give profit. Thus the firm's objective involves
getting as much of the market for itself as it can; which ofcourse, is not
compatible with Neo-classical model of 'perfect competition'.
Moreover Sraffa's critique, argued for firms rather than producing at the
point where marginal cost equals marginal revenue, instead the marginal revenue
of the final unit sold will normally become substantially greater than the
marginal cost of producing it, while output becomes constrained, not by marginal
cost, but the cost-and-difficulty of expanding sales at the expense of sales by
competition. As Keen notes, "Marketing expenses cannot be added in to rescue
the doctrine, since the true purpose of marketing is to alter the firm's demand
curve, and this only makes sense if firms produce differentiated products –
something the theory of perfect competition explicitly rules out". However,
Sraffa still not satisfied with this revised picture, which still remained
dominated by intersecting marginal revenue with marginal cost curves, instead
expressed a preference for a more 'realistic' model, which focused upon those
issues most relevant to actual businesses.
Sraffa argued that a firm faces falling average costs as their large
fixed costs get dispersed over a larger volume of sales, while as their variable
costs remain 'constant'-or-fall (where the cost curve for any one firm-orindustry gets represented by the product of 'interactions' between 'all'
industries, an issue ignored in Neo-classical treatment of a single market) with
higher output. Further to this the firm will have a target level of output
which it tries to exceed, with a target markup which it tries to maintain. The
size of the firm then becomes constrained by the size of the niche within the
given market, moreover the difficulty of raising finance for s much larger scale
of operation. The margin between costs of production, with target sale price
will become set by the degree of product differentiation within the industry,
competitive pressures, general market conditions, etc. Each firm will endeavor
to sell as much output as it can, but the level of output will become
constrained by the size of the firm's market niche, along with the marketing
efforts of rivals.
The "Cambridge Capital Controversy", involved dissident economists
pointing out that the Neo-classical justification for profits as the
contribution of capital to output was deeply flawed; while leading neo-classical
economists admitted that the critique appeared correct in the 1960s, yet
economic theory continues to use exactly the these 'concepts' which Sraffa's
(1926) critique showed to be completely invalid, in spite the definitive
capitulation by Samuelson.
Neo-classical economists use the Marginal Productivity Theory to justify
the current distribution of income, arguing that the widening gap between richand-poor simply reflects the market efficiently rewarding productiveness.
However, capital-goods cannot be aggregated together unless you give them a
price, but, to give them a price involves assuming a rate of interest equal to
the rate of profit, which entails that the rate of profit on capital is
meaningless, based on circular reasoning, whereby profits cannot equal any
contribution to production; there appears only one condition where profit equals
the marginal productivity of capital, when the capital to labor ratio is the
'same' in 'all' industries, which effectively means that there only involves one
industry. Thus if we consider a broadly defined industry, changes in their
conditions of supply-and-demand will therefore affect the distribution of
income. Consequently a change in the capital input will change output, but it
moreover changes the wage, thence the rate of profit, though the distribution of
income becomes to some significant degree determined independently of marginal
productivity, in order to work out prices, it first becomes necessary to know
the distribution of income. There is therefore nothing special about the prices
that apply in the economy, nor nothing special about the distribution of income,
reflecting simply the relative power of different groups in society; which Marx
termed as social classes. Hence why the rich get richer, while the poor poorer;
since the neo-classical theorists justify the Marginal Productivity Theory as
able to fairly distribute wealth, without the need for a 'benevolent authority'
(Smith's (1776): "the invisible hand"), then this failure flies in their face.
The notion of diminishing marginal costs as required to produce a
downward slopping supply curve, originally became invented to ensure that Neoclassical economics did not suggest that the economy would become dominated by
Big Business (monopolies), contrary to actual events; maintaining competition
eats into profits-and-costs (increasing instead of diminishing marginal costs),
whereas to out-compete-and-amalgamate makes economic sense. However, if
marginal returns remain 'constant' (at equilibrium) rather than falling, then
the Neo-classical explanation of 'everything' collapses; not only can economic
theory no longer explain how much a firm produces, it can explain nothing else;
for example, Employment and Wage Determination Theory asserts that the Real Wage
has an equivalent to the Marginal Product of labor: an employer will employ
further workers if a worker's output furthers profits, while diminishes cost,
where the worker's marginal product exceeds the real-wage. This explains the
underlying economic predilection for blaming 'everything' on high wages, which
can become expressed by John Kenneth Galbraith (1997) in the twin premises:
"that the poor don't work hard enough because they're paid too much, and the
rich don't work hard enough because they're not paid enough" (Keen, 2001).
Again, if in fact the output to employment relationship remains relatively
'constant', then the Neo-classical explanation for employment-and-output
determination collapses; with a flat production function, the marginal product
of labor will become 'constant', thence will never intersect the real-wage,
whereupon the output of the firm then cannot be explained by the cost of
employing labor.
Demand management measures, trying to boost aggregate demand to increase
employment, will moreover fail, because they cannot alter the marginal physical
product of labor, which can only occur by raising the productivity of the labor
on the supply side. Attempts to increase aggregate demand will thus merely
create inflation, without increasing the real returns to firms.
The important message here, that "you can't beat the market". This may
explain why the setting of a minimum wage, resulted in zero hour contracts.
Whatever society may favor as a fair wage level, else a socially desirable level
of employment, ultimately the market will decide both the income distribution,
aswell as the rate of unemployment. As Keen asserts: "Moreover, both these
market outcomes will be fair: they will reflect individual productivity on the
one hand, and the labor-leisure preferences of individuals on the other".
As argued the Neo-classical theory asserts the preference for a
meritocratic economy, however, as Keen asserts: "There are at least six serious
problems with meritocratic view of income distribution and employment
determination:
(1). the supply curve for labor can 'slope backwards' – so that a fall in wages
can cause an increase in the supply of labor;
(2). when workers face organized or very powerful employers, neoclassical theory
shows that workers won't get fair wages unless they also organize;
(3). Sraffa's observations about aggregation,...indicate that it is
inappropriate to apply standard supply and demand analysis to the labor
market;
(4). the basic vision of workers freely choosing between work and leisure is
flawed;
(5). this analysis excludes one important class from consideration – bankers –
and unnecessarily shows the income distribution game between workers and
capitalists as a zero-sum game. In reality, there are (at least) three
players in the social class game, and it's possible for capitalists and
workers to be on the same side in it – as they are now during the Great
Recession; and
(6). most ironically, to maintain the pretense that market demand curves obey
the Law of Demand, neoclassical theory had to assume that income was
redistributed by 'a benevolent central authority' (Mas-Colell et al. 1995)
prior to exchange taking place".
Moreover, Keen on "Benevolent Central Authority":
"...though neoclassical economists are normally vehement opponents of
the redistribution of income by the state – everything they normally argue,
should be decided by the market – their own theory of demand and supply only
works if, and only if, a 'benevolent central authority' (Mas-Colell et al. 1995)
redistributes income I order to 'keep the ethical worth of each person's
marginal dollar equal' (Samuelson 1956)".
Neo-classical theory’s key 'concept' of income distribution, involves
that factors get paid in accordance with their Marginal Contribution to Output
in the context of diminishing marginal returns. This entails that as the supply
of a factor increases, the return should fall. The difficulty alighted,
involves that it is not easy to see how one can 'add' units of capital together.
Workers can become aggregated by 'adding' up the number of hours they work,
after notionally standardizing for different levels of productivity by
multiplying the hours of skilled labor by some amount to reflect higher
productivity. Land can become aggregated by 'adding' up acres, while again
adjusting numerically for varying degrees of fertility. However, machines have
no apparent common 'property' apart from price. This involves how economic
theory aggregates capital, but moreover this involves an obvious circularity,
because the price of a machine reflects the profit expected from it, yet the
rate of profit involves the rate of profit to price.
To this Sraffa proposed an ingenious, 'logically' sound method of
aggregation: to reduce capital to dated inputs of labor, whereupon any items of
capital get produced by other items of capital-and-labor. When an economy has
remained in equilibrium for the indefinite past, it thus becomes possible to
regard the value of a machine as equal to the value of the machines used to
produce it + the value of the labor involved x a rate of profit to reflect the
passage of 'time'. If we then notionally treat the period of production as a
year, then if the Equilibrium Rate of Profit represents 5%, 1.05 x the value of
the input last year = (equals) the value of the machine this year. Similarly
this argument applies to 'all' the machines-and-labor inputs used to produce the
inputs, so that 'all' the machines-and-labor that produced them, etc. If we
repeat this process, whereupon each occasion reduce machinery inputs to the
machinery-and-labor used to produce them, then we get a set of labor terms, with
a declining, but never 0, residual of machinery inputs. Where each labor input
x both by wage 1 + the rate of profits raised to a power reflecting how many
years ago the input got made.
Keen provides an example: "If, for example, we are considering a machine
manufactured eleven production periods ago, then this term will be the amount of
direct labor bestowed in producing all the relevant components in the twelfth
year, times the wage, plus the capital input, all raised to the twelfth power.
It is therefore possible to substitute an expression in terms of labor for the
capital inputs used up in producing a given commodity". Where Keen goes on to
point out: "This correspondence is not exact, but it can be made accurate to any
level of 100 percent by continuing the process of reduction for being long
enough".
Whereby we can now approximately (due to the irreducible commodity residue left
from the reduction process) express the value of a machine in terms of the 'sum'
of the value of labor inputs used to produce it. Each component in this 'sum'
consists of a physical quantity of labor x by 2 terms: one representing the
wage, the other representing the impact of accumulated profit over 'time'. The
former term represents a negative function of the rate of profit; the latter
represents a positive function of the rate of profit, raised to a power.
Profit Rate
(%)
Years
0
0
1
2
3
4
5
10
20
21
22
23
24
25
1
0.96
0.92
0.88
0.84
0.80
0.60
0.20
0.16
0.12
0.08
0.04
0.00
1
1
0.97
0.94
0.91
0.87
0.84
0.66
0.24
0.19
0.15
0.10
0.05
0.00
2
1
0.98
0.96
0.93
0.91
0.88
0.73
0.29
0.23
0.18
0.12
0.06
0.00
3
1
0.99
0.98
0.96
0.94
0.93
0.80
0.35
0.28
0.22
0.15
0.08
0.00
4
1
1.00
1.00
0.99
0.98
0.97
0.88
0.41
0.34
0.27
0.18
0.09
0.00
5
1
1.01
1.02
1.02
1.02
1.02
0.97
0.50
0.41
0.32
0.23
0.12
0.00
10
20
1
1.06
1.12
1.18
1.24
1.30
1.56
1.24
1.08
0.88
0.63
0.34
0.00
1
1.17
1.37
1.59
1.84
2.12
4.04
7.67
7.74
6.40
5.03
2.95
0.00
25
1
1.23
1.51
1.84
2.24
2.71
6.50
19.08
18.78
17.31
14.15
8.66
0.00
Table 6.
The impact of the rate of profit on the measurement of capital.
From Steve Keen (2011) "Debunking Economics".
Whereas the former will fall in size as the rate of profit rises; the latter
will rise, but will furthermore raise more for inputs made a long 'time' ago.
This combination of opposing forces, one term that falls as r falls, the other
that rises as r falls, evokes the possibility that one result can prevail for a
'time', only to become overwhelmed by the opposite result at a higher rate of
profit. Therefore, the individual terms that 'interact' to determine the value
of an item of capital can rise for a while as the rate of profit rises, only to
fall as the rate of profit raises still further.
Of course, with regards to firms, factories, etc., just as with the
agricultural industry, the capacity to expand production is not limited, instead
factories usually have a surplus area of construction built-in to their design
which allows any further necessary expansion of their current production line,
future diversifying as required by new orders, etc., otherwise a factory's
company will inevitably have other manufacturing sites which can diversify,
etc., as to the requirements of the demand economy. Hence, Neo-classical
theory's assumption that firms, etc., expand only to requirements of the
manufacturing process, thus ultimately restricting profits possible with
marginal productivity, having no further surplus capacity for production is
false-to-facts.
The Notion Of Equilibrium:
A. Meritocratic Equilibrium:
Equilibrium represented a fundamental aspect of a market social order. From the
beginning, economists assumed that the market system would achieve equilibrium.
Consequently, equilibrium became flagged by neo-classical economists as an
advantage of the free-market over any other system; equilibrium therefore became
a fundamental notion of the economic defense of 'Capitalism': the equilibrium of
the 'capitalist' market would replace the legislative order of the now defunct
feudal 'hierarchy'.
More importantly, whereas the feudal order endowed only the well born
with welfare, the equilibrium of the market promised the best possible welfare
for 'all' members of society. Where the level of individual welfare would
reflect the individual's contribution to society: "people would enjoy the
lifestyle they deserved, rather than the lifestyle into which they had been
born".
Neo-classical economists argued that the Equilibrium Ratio at which 2
products exchange gets determined by the ratio of their Marginal Utilities to
their marginal costs. However, by the middle of the 19th-century instead of the
promised equilibrium, 'Capitalism' became racked by cycles of boom-and-bust,
with enormous disparities of wealth. Where a major depression occurred roughly
'every' 20 years, worker's conditions would improve, but then rapidly
deteriorate, prices rise-and-fall, banks expand-and-collapse. New robber barons
arose only to replace the barons of old. It appeared that instead of delivering
a meritocratic equilibrium, 'Capitalism' had instead delivered unbalanced chaos;
systematically preventing the advancement of humanity.
Consequently, Socialism arose as the natural counter-reaction to
'Capitalism'.
B. Keynes' General Theory:
Keynes' (1936) General Theory, conceived-and-published during the Great
Depression (1929-39 approx), had brought to light that macro-economics had many
intractable problems. Up till then, economists could imagine that markets might
occur out of equilibrium at any one moment, not just the market for labor-ormoney, but the entire economy, the 'sum' of 'all' those individual markets,
which must balance out. Neo-classical economists believed in Say's Law, after
Jean Baptiste Say (1767-1832), an exchange-only economy: an economy in which
goods 'exist' at the outset, but where no production takes place; whereupon the
market simply enables the exchange of 'pre-existing' goods; otherwise put,
"supply creates its own demand". Thus Say's Law appears best suited to the
economic irrelevance of an exchange-only economy, otherwise a production economy
in which growth does not occur; further from which became derived the notion
that involuntary unemployment-and-recessions are impossible under free-market
'Capitalism'. As Say (1821) asserted:
"Every producer asks for money in exchange for his products, only for
the purpose of employing that money again immediately in the purchase of another
product; for we do not consume money, and it is not sought after in ordinary
cases to conceal it: thus, when a producer desires to exchange his product for
money, he may be considered as already asking for the merchandise which he
proposes to buy with this money. It is thus that the producers, though they
have all of them the air of demanding money for their goods, do in reality
demand merchandise for their merchandise".
However, Keynes' attempt to refute Say's notion, led to mis-understanding-andconfusion, in part:
"(1). In a given situation of technique, resources and costs, income (both
money-income and real income) depends on the volume of employment N.
(2). The relationship between the community's income and what it can be
expected to spend on consumption, designated by D1, will depend on the
psychological characteristic of the community, which we shall call its
propensity to consume. That is to say, consumption will depend on the
level of aggregate income and, therefore, on the level of employment N,
except when there is some change in the propensity to consume.
(3). The amount of labor N which the entrepreneurs decide to employ depends on
the sum (D) of two quantities, namely D1, the amount which the community
is expected to spend on consumption, and D2, the amount which it is
expected to devote to new investment. D is what we have called above the
effective demand.
(4). Since D1 + D2 = f(N), where f is the aggregate supply function, and since,
as we have seen in (2) above, D1 is a function of N, which we may write
c(N), depending on the propensity to consume, it follows that f(N) – c(N)
= D2.
(5). Hence the volume of employment in equilibrium depends on (i) the aggregate
supply function, (ii) the propensity to consume, and (iii) the volume of
investment, D2. This is the essence of the General Theory of Employment.
6). For every value of N there is a corresponding marginal productivity of
labor in the wage-goods industries; and it is this which determines the
real wage. (5) is, therefore, subject to the condition that N cannot
exceed the value of labor. This means that not all changes in D are
compatible with our temporary assumption that money-wages are constant.
Thus it will be essential to a full statement of our theory to dispense
with assumption.
(7). On the classical theory, according to which D = f(N) for all values of N,
the volume of employment is in neutral equilibrium for all values of N
less than its maximum value; so that the force of competition between
entrepreneurs may be expected to push it to this maximum value. Only at
this point, on the classical theory, can there be stable equilibrium.
(8). When employment increases, D1 will increase, but by so much as D; since
when our income increases our consumption increases also, but not by so
much. The key to our practical problem is to be found in this
psychological law. For it follows from this that the greater the volume
of employment the greater will be the gap between the aggregate supply
price (Z) of the corresponding output and the sum (D1) which the
entrepreneurs can expect to get back out of the expenditure of consumers.
Hence, if there is no change in the propensity to consume, employment
cannot increase, unless at the same time D2 is increasing so as to fill
the increasing gap between Z and D1. Thus – except on the special
assumptions of the classical theory according to which there is some force
in operation which, when employment increases, always causes D2 to
increase sufficiently to fill the widening gap between Z and D1 – the
economic system may find itself in stable equilibrium with N at a level
below full employment, namely at the level given by the intersection of
the aggregate demand function with the aggregate supply function".
Figure 5.
John Maynard Keynes (June 5, 1883 - April 21, 1946).
Neo-classical economists not understanding Keynes, tried to reconcile Say's Law
with Keynes, via Léon Walras' (1874) Law: "the proposition that the sum of
notional excess demands is zero". R.W. Clower, with A. Leijonhufvud (1973), for
example, asserted that Keynes, along with Walras were not incompatible, since
Walras' Law applied effectively only in equilibrium. Out of equilibrium, then,
though the 'sum' of notional excess demands still represents 0, the 'sum' of
effective demands could be negative.
Keynes' General Theory has the advantage of an attempt to explain the
phenomenon of employment related to demand-and-income via mathematics, however,
Marx (1885), had originally formulated this argument; as to why Keynes chose to
not even quote Marx, I do not wish to speculate.
Marx's critique of Say's Law went to the heart of Walras' Law.
Marx
rejected Say's premise that each producer asks for money in exchange for the
products produced, in order to immediately use that money to purchase another
product. Whereas both Say-and-Walras' Laws assert that people simply desire to
consume commodities, instead Marx saw that the point of 'Capitalism' entails the
fundamental desire for the accumulation of wealth. There occurs something very
odd within Say's Law, that insists that the 'sum' of 'all' notional excess
demands equals 0, thus represents a model of the 'capitalist' economy without
production moreover, most importantly without capitalists; hence Say's Law is
invalid in a production economy with growth; the point of both Say-and-Walras'
Laws: a moral prediction of the functioning of a 'capitalist' market, without
agents taking (thieves; since taking more than they can give), nor those giving
(losing out; since giving more than they can afford), however, contrary to being
very odd, capitalists are not aberrant in a market-economy, but the 'essence' of
it, taking more than they give without being 'thieves'. As such Say-and-Walras'
Laws apply not to a self-interested 'capitalist' market-economy, but to an
exchange-only market (which Marx called simple Commodity Production; an economy
in which goods 'exist' at the outset, but where no production takes place, this
market simply enables the exchange of 'pre-existing' goods), asserting that
people simply want to consume commodities. As Marx (1861) asserts:
"It must never be forgotten, that in capitalist production what
matters is not the immediate use-value but the exchange-value, and, in
particular, the expression of surplus-value. This is the driving motive of
capitalist production, and it is a petty conception that – in order to reason
away the contradictions of capitalist production – abstracts from its very basis
and depicts it as a production aiming at the direct satisfaction of the
consumption of the production".
Such that capitalists clearly become fundamental to 'Capitalism', where their
'behavior' directly contradicts the Say-and-Walras' assumption that 'every'
agent's intended excess demand equals 0. As Marx (18885) argued:
"The capitalist throws less value in the form of money into the
circulation than he draws out of it...Since he functions...as an industrial
capitalist, his supply of commodity-value is always greater than his demand for
it. If his supply and demand in this respect covered each other it would mean
that his capital had not produced any surplus-value...His aim is not to equalize
his supply and demand, but to make the inequality between them ...as great as
possible".
For Marx still had to explain how this inequality could become achieved without
'robbing' other participants in the market, whilst without violating the
principle that commodities get brought-and-sold at 'fair' values. Marx
explained that the market process had to include a production stage, where the
quantity-and-value of output exceeded the value of inputs; such that in both
Marx-and-Sraffa's terms: a surplus gets produced. The capitalist pays a fair
price for the raw materials, further a fair wage to the employee, these costs
then get combined into a production process which generates commodities for
sale, whereupon the physical quantity of commodities combined with their
monetary value exceed the quantity-and-value of inputs. The commodities then
get sold for more than the cost of the raw materials-and-workers'-wages, thus
yielding a profit. This profit allows the capitalist to fulfill their desire to
accumulate wealth, without robbing any other market participants, whilst without
having to buy commodities below their value, thence sell them above it.
Marx formulated this 'analysis' in terms of 2 'circuits', the "Circuit of
Commodities", furthermore the "Circuit of Capital". In the Circuit of
Commodities, people come to market with commodities, where Marx formalized thus,
CommodityMoneyCommodity:
C-M-C
where C, Commodity.
M, Money.
Equation 2.
Though Marx discussed various ways in which this circuit could fail, primarily
to delays between the sale of one commodity, with the purchase of the next; but
generally it obeys Walras' Law, where each agent desires to convert commodities
of a given value into different commodities of equivalent value.
However, in the Circuit of Capital, people came to market with money,
with the intention of turning this money into more money; whereupon these agents
buy commodities (with money), specifically labor-and-raw-materials, put these to
work in a factory to produce other commodities, then in turn sell these
commodities for more money (with hope), thus making a profit. Marx formalized
thus, MoneyCommodityMore Money:
M-C-M+
Equation 3.
Now, the complete circuit, which emphasizes the fallacy behind Walras' Law:
M-C(L, MP)...P...C+c-M+m
Equation 4.
where L, Labor.
P, Production.
MP, Means of production.
C+c, Different commodities of greater value.
M+m, Sale of commodities generating more money.
Therefore, Marx's circuit specifically violates both Say-and-Walras' Laws.
Rather than simply wanting to exchange one set of commodities for another of
equivalent value, the agents in this circuit wish to complete it with more
wealth than they started with. If we focus upon the commodity stages of the
circuit, then, as Marx asserted, these agents wish to supply more than they
demand, such to accumulate the difference as profit which thus furthers their
wealth. Their supply, involves the commodities they produce for sale; their
demand, the inputs to production they purchase, the labor-and-raw-materials. In
Say's Law, the 'sum' of these, their excess demand, is negative. However, when
both circuits get 'summed', the total of 'all' excess demands in a 'capitalist'
economy becomes likewise negative, though prior to the introduction of credit.
However, Keynes though having explained this in a draft of The General
Theory, then left it out. Keynes had made the observation that Marx had
realized that, as D. Dillard (1984) cites:
"(T)he nature of production in the actual world is not C-M-C', i.e.
ofexchanging commodity (or effort) for money in order to obtain another
commodity (or effort). That may be the standpoint of the private consumer. But
it is not the attitude of business, which is a case of M-C-M', i.e., of parting
with money for commodity (or effort) in order to obtain more money".
Keynes then continued in a footnote that this vision of 'Capitalism' as having 2
circuits, one of which motivated solely by the desire to accumulate wealth, in
turn implied the likelihood of periodic crises when expectations of profit were
not met:
"Marx, however, was approaching the intermediate truth when he added
that the continuous excess of M' (over M) would be inevitably interrupted by a
series of crises, gradually increasing in intensity, or entrepreneur bankruptcy
and underemployment, during which, presumably M must be in excess. My own
argument, if it is accepted, should at least serve to effect reconciliation
between the followers of Marx and those of Major Douglas, leaving the classical
economics still high and dry in the belief that M and M' are always equal".
Whereupon instead Keynes later substituted his own convoluted reasoning for
Marx.
Marx (1867) argued that, in a highly simplified economy consisting of
just capitalists-and-workers, there would be cycles in employment-and-income
shares:
"A rise in the price of labor, as a consequence of accumulation of
capital...(means that) accumulation slackens in consequence of the rise in the
price of labor, because the stimulus of gain is blunted. The rate of
accumulation lessens; but with its lessening, the primary cause of that
lessening vanishes, i.e., the disproportion between capital and exploitable
labor-power.
The mechanism of the process of capitalist production removes the very
obstacles that it temporarily creates. The price of labor falls again to a
level corresponding with the needs of the self-expansion of capital, whether the
level be below, the same as, or above the one which was normal before the rise
of wages took place...
To put it mathematically: the rate of accumulation is the independent,
not the dependent, variable; the rate of wages, the dependent, not the
independent, variable".
Therefore Marx's model thus:
(1). A high rate of growth (ouput) leads to a high level of employment.
(2). The high level of employment encouraged workers to demand large wage rises,
which reduced profits.
(3). The reduced level of profits causes investment to decline, while growth to
slow.
(4). The slower rate of growth led to increasing unemployment, which in turn led
to workers accepting lower wages.
(5). Eventually the fall in workers' share of output restored profit to levels
at which investment would resume, leading to a higher rate of growth-andemployment levels.
(6). This once again leads to high wage demands, thus completing the cycle.
(7). Etc.
Figure 6.
Phillips Curve after A.W. Phillips (1968), from "Models For The Control Of
Economic Fluctuations".
Scatter-plot of the rate of change of wage-rates, to that of the percentage
unemployment for the years 1861-1913.
This cycle can moreover become stated in terms of causal relationships between
key economic variables (amount of capital, level of growth, etc), which shows
that the process Marx described, appears based on an accurate view of the entire
structure of the economy, furthermore an accurate prediction that this would
lead to cycles in income distribution-and-employment, rather than equilibriumor-breakdown:
(1). Amount of physical capital determines the amount of growth.
(2). Growth determines employment.
(3). Rate of employment determines the rate of change of wages (known as the
"Phillips Curve", a relationship after A.W. Phillips, 1968; refer to
Figure 6 below).
(4). Profit = (wages x employment determines the wage bill) - growth.
(5). Profit determines the level of investment.
(6). Investment determines the rate of change of capital, thus closes the causal
loop.
(7). Etc.
In mathematical formulation, the model reduces to 2 formulae:
(1). Rate of change of workers' share of growth equals workers' wage demands –
rate of productivity growth:
x
WS 
t
= WD – MT
Equation 5.
(2). Rate of change of employment equals the rate of growth of output population growth + technological change:
x
E 
t
= OT – PT + TT
Equation 6.
where WS, Workers' share of growth.
x
, Rate of change.
t
WD, Workers' wage demands.
MT, Rate of productivity growth.
E, Employment.
OT, Rate of growth of output.
PT, Population growth.
TT, Technological change.
Whereby this mathematical model thus generates the cycle envisaged by Marx.
Figure 7.
'Hypothetical' business life-cycle of a company.
This cycle principle is not limited to businesses-or-products; it could
represent the situation in many different types of groups, volunteer
organizations, churches, predator-prey limit cycles, an entire society, etc.
Rather than converging to equilibrium values, workers' share of growth, aswell
as the rate of employment both cycle indefinitely.
For a long-time, economics has concentrated on a special kind of Strange
Attractor, namely Fixed-Point (otherwise Equilibrium-Point) Attractors, where
the term equilibrium mostly gets used in economic meaning to indicate the
congruence of supply-and-demand in a market and/or planned-and-actual individual
'actions'. When wages-share-and-employment get plotted against each other, this
results in a closed loop; representing in a far less complex structure than
Hans-Walter Lorenz's (1987, 1989) model, but has in common that the model does
not converge to an equilibrium (such as lies in the centre of the loop), but
orbits around it indefinitely.
Figure 8.
The diagram above shows a Cyclical Attractor, involving a dynamic (not globalor-local 'stability') around (not possibly complicated convergence to a fixedpoint attractor) an attractor in the form of a closed orbit. Where,
"Definition: A closed orbit Γ is called a limit cycle if there is a tubular
neighborhood U(Γ) such that for all x  U(Γ), any flow Φt(x) approaches the
closed orbit". Thus if a closed orbit represents an attractor it will become
termed a limit cycle, where: "A point x is said to be in a closed orbit if there
exists a t0 such that Φt(x) = x".
Hans-Walter Lorenz (1989) "Nonlinear Dynamical Economics And Chaotic Motion".
The non-Say/Walras' Law vision of the economics shared by Marx, Keynes,
J.A. Schmpeter, along with Hyman Minsky, thus accords with the manifest
instability of the macro-economy, whereas Walras' Law asserts that, despite
appearances to the contrary, the macro-economy 'really is stable'; however, this
potential for instability actually becomes a necessary aspect of the potential
for growth, thus instability, is not a terrible thing, but in fact fundamental
to any dynamic, growing system.
C. Uncertainty Of Risk:
(a). Probability Confused As Risk:
The key 'concept' in Keynes' 'summary' involved the impact of expectations upon
investment, when those expectations involved what might happen in an uncertain
future.
Investments become undertaken to augment wealth, yet the outcome of any
investment depends upon economic circumstance in the relatively distant future.
Since the future cannot be known, investment necessarily gets undertaken on the
basis of expectations formed under uncertainty. Keynes took pains to
distinguish between the 'concepts' of uncertainty from that of risk. Risk
occurs when some future event can only remain one of a number of known
alternatives (thus applies to situations in which the regularity of past events
becomes a reliable guide to the course of future events), but when there remains
a known history of previous outcomes which enables an assignment of a reliable-
and-definite probability to each possible outcome; for example, dice can land on
1 of 6 sides, where each number has 1 in 6 chance of turning up, when the theory
of probability via statistical estimates can then allow the prediction of the
chances of various patterns of numbers occurring in future rolls of the dice.
Uncertainty is not the 'same', which occurs when some future event cannot remain
one of a number of known alternatives (thus applying when the past provides no
reliable guide to future events), which in economics instead concerned things
such as the chance for the rate of interest 20 years in the future; here Keen
gives for an example: asking someone out, say that you know that this particular
individual has gone out with 20% of those who had asked her, however, this is no
guide to what can happen when you ask her out, since attraction between 2 people
remains a unique event, involving a mass of complexities which cannot be so
readily explained, thus allow prediction.
Probability theory cannot be used to help guide us in these circumstances
because there is no reliable prior history to go on, where the outcomes can
become constrained to any known 'finite' set of possibilities. Yet faced with
uncertainty, but compelled to function in spite of it, we develop conventions to
help us cope; Keynes (1936), in explaining this convention:
"How do we manage in such circumstance to behave in a manner which
saves our faces as rational, economic men? We have devised for the purpose a
variety of techniques, of which much the most important are the three following:
(1). We assume that the present is a much more serviceable guide to the future
than a candid examination of past experience would show it to have been
hitherto. In other words we largely ignore the prospect of future changes
about the actual character of which we know nothing.
(2). We assume that the existing state of opinion as expressed in prices and the
character of existing output is based on a correct summing up of future
prospects, so that we can accept it as such unless and until something new
and relevant comes into the picture.
(3). Knowing that our own individual judgment is worthless, we endeavour to fall
back on the judgment of the rest of the world which is perhaps better
informed. That is, we endeavour to conform with the behavior of the
majority or the average. The psychology of a society of individuals each
of whom is endeavouring to copy the others leads to what we may strictly
term a conventional judgment".
Keynes notes that expectations formed in this manner become 'certain' to be
disappointed, but there is no other way in which to form them. Expectations
therefore bound as fragile, since future circumstances 'almost' inevitably turn
out to be different from what we expected. This volatility in expectations will
entail sudden shifts in investor (-speculator) sentiment; which will suddenly
change the values placed on assets, to the detriment of anyone whose assets
remain in non-liquid form.
As a consequence, money plays a fundamental role in a market-economy
because of instant liquidity. The extent to which we desire to hold our wealth
in the form of non-income-earning money, rather than income-earning, but
illiquid assets, as Keynes posits: "is a barometer of the degree of our distrust
of our own calculations and conventions concerning the future".
This "Liquidity Preference", Keynes argued, determines the rate of
interest: the less we trust our fragile expectations of the future, the higher
the rate of interest has to be to entice us to sacrifice unprofitable but safe
cash for potentially profitable but volatile assets.
In assets themselves investors face 2 broad alternatives: lending money
at the prevailing rate of interest (effectively purchasing bonds), otherwise
buying shares which confer part-ownership of capital assets. John M. Blatt
(1983), argues that both activities effectively involve "placement", rather than
investment proper, however, which for Blatt, along with I. Boyd (1988), entails
the building of new capital assets. New capital assets become produced not for
their own sake, but in expectation of profits, where profits will come in the
form of capital gain, if their market prices (the result of placement activity)
exceed their costs of construction. Physical investment therefore, moreover
becomes extremely volatile because, as Keynes (1937), assets: "it depends on two
sets of judgments about the future, neither of which rests on an adequate or
secure foundation – on the propensity to hoard (the flip side of liquidity
preference) and on opinions of the future yield of capital-assets". These 2
factors, which play a key role in determining how much investment takes place,
become likely to feed upon, further destabilize each other; if we become more
pessimistic about the future prospects of investments, we become likely to want
to hoard more, not less.
Having explained why expectations have become so important in economic
theory-and-practice, why uncertainty makes expectations so fragile-and-volatile,
further how these factors affect the rate of interest, along with the level of
investment, Keynes returned once more to an attack on Say's Law. Keynes divided
expenditure into consumption, which appears relatively stable, further
investment, which appears highly volatile, to which he emphasized that
investment becomes the key determinant of the level-and-rate of change of
output, hence employment. Keynes' theory therefore represented a theory "of why
output and employment are so liable to fluctuation". Keynes then gave a
'summary', in which expectation, investment, along with uncertainty had pivotal
roles:
"The theory can be summed up by saying that, given the psychology of
the public, the level of output and employment as a whole depends on the amount
of investment. I put it in this way, not because this is the only factor on
which aggregate output depends, but because it is usual in a complex system to
regard as the causa causans that factor which is prone to sudden and wide
fluctuation.
More comprehensively, aggregate output depends on the propensity to hoard
on the policy of the monetary authority as it affects the quantity of money, on
the state of confidence concerning the prospective yield of capital-assets, on
the propensity to spend and so the social factors which influence the level of
the money-wage. But of these several factors it is those which determine the
rate of investment which are most unreliable, since it is they which are
influenced by our views of the future about which we know so little".
Keynes peppered his General Theory paper with observations about how
conventional economics ignored the issue of uncertainty, further upon how
expectations become formed under uncertainty, by simply assuming the problem
away: "I accuse the classical economic theory of being itself one of these
pretty, polite techniques which rises to deal with the present by abstracting
form the fact that we know very little about the future".
Finally, in a departure from the General Theory of just a year earlier,
Keynes criticized the 'concept' of the Marginal Efficiency of Capital: the ratio
of the yield of newly produced capital assets to their price. Whereas Keynes
had used this 'concept' extensively in the General Theory, here he argued that
it is indeterminate, since the price of capital assets remains so volatile,
where there will occur a different marginal efficiency of capital for 'every'
different level of asset prices. However, rather than becoming a determinant of
investment, the marginal efficiency of capital might simply involve a by-product
of the level of investment, combined with current expectations.
These 'concepts', remained especially difficult for economists who became
trained in the Neo-classical tradition in which, Keynes argues: "at any given
time facts and expectations were assumed to be given in a definite and
calculable form; and risks, of which, though admitted, not much notice was
taken, were supposed to be capable of an exact actuarial computation". But
instead of the unleashing of a revolution in economic 'thought', whereupon
economists would have fought to escape from these, as Keynes puts it, "habitual
modes of thought and expression", which had gripped them prior to the Great
Depression, economists bifurcated into 2 camps: a minority which called
themselves Post-Keynesians, progressed with Keynes' revolutionary vision; whilst
the majority, who only paid at best lip-service to some of Keynes words.
(b). Risk Of Efficient Markets:
Non-economists often assume that the term efficient refers to the speed at which
transactions take place on the stock-market, and/or cost per transaction; whence
with the rise in use of computers makes the former seem sensible. Market
efficiency often then becomes alleged to mean: "investors are assumed to make
efficient use of all available information"; which again seems sensible.
However, the economic 'concept' of efficiency means something quite different
from usual usage, whereupon in the case of stock-markets, it means at least 4
things:
(1). That the collective expectations of stock-market investors involve accurate
predictions of the future prospects of companies.
(2). That share prices fully reflect 'all' information pertinent to the future
prospects of traded companies.
(3). That changes in share prices entirely become due to changes in information
relevant to future prospects, where that information arrives in an
unpredictable-and-random way.
(4). That therefore stock prices "follow a random walk", so that past movements
in prices give no information about what future movements will be, just as
past rolls of dice cannot be used to predict what the next roll will
entail.
These premises represent a collage of assumptions-and-conclusions of the
Efficient Markets Hypothesis (EMH), while the Capital Asset Pricing Model
(CAPM), which involved formal extensions to Fisher's (1929, pre-Depression)
time-value of money theories. However, like Fisher theories of old, these newer
theories, micro-economic in nature, presumed that finance markets remain
continually in equilibrium. Though there appears several economists who
developed this sophisticated equilibrium 'analysis' of finance, we shall focus
on the work of W.F. Sharpe.
An asset that gives a high return, must have a higher risk, than one
which gives a lower return. If the investor wants however a higher rate of
return, they can invest in corporate bonds, else in shares; if however an
investor wants complete safety, then government bonds. Corporate bonds hold the
risk of default, while shares can rise-and-fall unpredictably in price, so
cannot provide a guaranteed income flow. Thus there remains a trade-off between
return-and-risk: a higher return can become earned, but only at the cost of a
higher level of risk.
Sharpe (1964), provided an explanation for this in terms of the theory of
individual 'behavior', as outlined using indifference curves. Sharpe began by
assuming that "an individual (rational investor), views the outcome of any
investment in probabilistic terms; he is willing to act on the basis
of...expected value and standard deviation". An investor gets greater utility
from a higher return than a lower one, while a lower utility from an asset with
a high standard deviation than a lower one. This assumption enabled Sharpe to
plot an investor's preferences in terms of indifference curves, with the 2
'goods' involving risk-and-return; however, there involved one twist compared to
the standard indifference curve 'analysis' as previously outlined: risk
represents a 'bad', not a 'good', while a consumer maximizes their utility by
experiencing as little risk as possible. So the most desirable investment
involves one that gives a very high return with very little risk. Consequently,
rather than drawn to show that more of both goods becomes better, these
indifference curves get drawn to show that more return, with less risk becomes
better.
With standard goods, the consumer prefers more of both, so the desirable
direction to move on the indifference curve, entails up-and-to-the-right, which
means the consumer, should feel better with the obtaining of more of both
commodities. However, with return-and-risk involving the 'goods', the desirable
direction involves more return, but less risk. Sharpe drew expected return on
the horizontal axis, while risk on the vertical, so the most desirable direction
involved going to the right, which gave the consumer more return, while instead
down, which gave the consumer less risk. Therefore the highest utility comes
from the highest-return-and-lowest-risk.
Though this takes care of the consumer's preferences, in order to
complete the 'analysis', Sharpe had to include a budget line aswell, which again
provided a twist compared to the 'analysis' of consumption. Rather than the
budget line representing the investor's income, the budget line involved the
spectrum of investments that an investor could make. Each individual investment
represented a share of the company (strictly, this could involve anything in
which one could invest, but the theory applied as if investments became
restricted to shares), while 'all' the information about them became reduced to
their expected returns, combined with the standard deviation of their expected
returns. Consequently, these could show any pattern, where some investments
could have a very high expected return, with low variability, while others a low
expected return, with high variability, etc. Each company could then become
described by a point on the graph of return versus risk, where the horizontal
position represented the return, while the vertical position the risk.
This then resulted in a Cloud of Possible Investments, potentially
available to investors, where the most desirable investments involved those with
high return, whereupon the further out along the horizontal axis the better,
while with low risk, the power down on the vertical axis the better. But with
this picture of investor 'behavior', Sharpe showed that the only investments
that appear 'rational' for this investor involve those that fall on the edge of
the cloud of possible investments, which he labels the Investment Opportunity
Curve (IOC); these investments give the highest return, with the lowest risk
possible. Any other combination that is not on the edge of the cloud can become
topped by one farther out that has both a higher return with a lower risk; but
since diversification reduces risk, 'all' investments along this edge must
involve portfolios rather than individual shares.
If this represented the end of the matter, then the investor would choose
the particular combination that coincided with their preferred risk-return
trade-off. However, it becomes possible to combine share-market investments
with a bond that has much lower volatility, where Sharpe assumed the occurrence
of a bond that paid a very low return, but had no risk. Sharpe linked bond-andshare investments with one further assumption: that the investor could borrow as
much as they wanted at the riskless rate of interest. This assumption entailed
that, in Sharpe's model, an investor could invest some money in the riskless
(but low-return) bond, whilst some money in risky (but higher-return) shares to
create an investment portfolio.
This portfolio gets represented by a 'straight' line linking the riskless
bond with a selection of shares; where the only selection that made sense
involved that of the IOC, whilst tangential to a line drawn through the riskless
bond; whereupon Sharpe called this line the Capital Marker Line (CML). Thus
with borrowing the investor's risk-return preferences no longer determined which
shares bought, instead, they determined where the investor sat on the CML.
Thus an ultra-conservative investor would just buy the riskless bond;
which if the investor brought nothing else, places them on the horizontal axis
(where risk = 0), but only a short distance out along the horizontal axis, which
entails only a very low return. Someone happy with the market return, involving
the return on an investment in shares alone, would buy only shares. Someone who
wanted a higher return than shares can provide, could do so by borrowing money
at the riskless rate, while buying shares with this borrowed money, aswell as
their own; in the 'real' world, thus termed buying shares on margin.
Then Sharpe however, encountered a problem: aswell as each investor
having a different set of indifference curves between risk-and-return, each
would further have a different opinion about the return-and-risk that related
with each possible investment. Thus Investor C might 'think' that Investment F,
say the Internet company Yahoo, would become likely to yield a low return at a
high risk, while Investor A might expect that Yahoo will give a high returns
with little variation. In other words, each investor would perceive a different
cloud of investment opportunities, such that the edge of the cloud of investment
opportunities, the IOC, would be different for each investor, in terms of both
location, along with the investments in it.
Similarly, lenders may change a different rate of interest to each
borrower, so that the Location P would differ between individuals. They might
further restrict credit to some (even 'all') investors, so that the length of
the line between each investor's P would differ, rather than becoming infinitely
long, as Sharpe assumed, it might not even be a line, but could well involve a
curve, with lenders charging a higher rate of interest as borrowers committed
themselves to more-and-more debt. In other words, with each Neo-classical
theorem, Sharpe encountered an aggregation problem in going from the isolated
individual to the level of society, whereupon Sharpe did the time-honored
approach of assuming the problem away. Sharpe assumed:
(1) That 'all' investors could borrow-or-lend as much as they liked at the
'same' rate.
(2). That investors 'all' agreed on the expected prospects for 'each-and-every'
investment.
Sharpe did however, admit that these represented extreme assumptions, but he
justified them by an appeal to the methodological authority of Friedman's
(1953), "assumptions don't matter" rule; as Sharpe asserts:
"In order to derive conditions for equilibrium in the capital market
we invoke two assumptions. First, we assume a common pure rate of interest,
with all investors able to borrow or lend funds on equal terms. Second, we
assume homogeneity of investor expectations: investors are assumed to agree on
the prospects of various investments – the expected values, standard deviations
and correlation coefficients described in Part II. Needless to say, these are
highly restrictive and undoubtedly unrealistic assumptions. However, since the
proper test of a theory is not the realism of its assumptions but the
acceptability of its implications, and since these assumptions imply equilibrium
conditions which form a major part of classical financial doctrine, it is far
from clear that this formulation should be rejected – especially in view of the
dearth of alternative models leading to similar results".
Though Sharpe does not say this, he moreover assumes that investor expectations
remain accurate: that the returns investors expect firms to achieve will
actually happen.
However, with these assumptions established, Sharpe had simplified the
problem: the riskless asset, the 'same' for 'all' investors; the IOC the 'same'
for 'all' investors, therefore 'all' investors would want to invest in some
combination of the riskless asset, using the 'same' share portfolio. The only
difference, involved the investor risk-return preferences. However, since 'all'
investors will attempt to buy the 'same' portfolio, while no investor will
attempt to buy any other investment, the market mechanism kicks-in, whereupon
this one portfolio rises in price, while 'all' other investments fall in price.
This process of re-pricing investments then alters their returns, thence
flattens the edge of the IOC.
The final step in Sharpe's argument relates the return on any single
share to entire market return, with a relation known these days as the share's
Beta (): this formula asserts that the expected return on a share = the riskfree rate (P) +  x the difference between the entire market return, along with
the risk-free rate;  represents a measure of the ratio of the variability of a
given share's return to the variability of the market index, along with the
degree of correlation between the share's return, aswell as the market index
return; entailing that the efficient markets hypothesis asserts that the more
volatile a share's returns, the higher their expected yield; thus a trade-off
between risk-and-return.
Sharpe's paper formed the core of EMH, while others made further
inclusions, such as the argument that how a firm gets internally financed has no
impact on their value, that dividends are irrelevant to a share's value, etc.
However, if this set of assumptions were not incorrect, then the premise cited
earlier would not be untrue: the collective expectations of investors will
remain an accurate prediction of the future prospects of companies; share prices
will fully reflect 'all' information pertinent to the future prospects of traded
companies; which involves 3 variations, known as weak, semi-strong, strong forms
of EMH. Whereupon changes in share prices will entirely involve changes in
information relevant to future prospects; whilst prices will "follow a random
walk", so that past movements in prices give no information about what future
movements will entail.
D. Monetarism, Friedman-Lucas' Adaptive Expectations:
Instead as typical of the mis-interpretation of Keynes, John Hicks (1937), tried
to interpret Keynes mathematically, in his IS-LM model: IS curve showed 'all'
those combinations of the rate of interest (i) combined with the level of income
(I) which yielded equilibrium in the goods market; LL curve (which economists
today call the LM curve) showed 'all' those combinations of the rate of
interest, combined with the level of income which gave equilibrium in the
money-market.
Keynes in his criticism of the classical economists meant the Neoclassical economics, went on to 'summarize' the Classical theory with 3
formulae:
(1). The amount of money determined total output (output represented some
'constant' x the money stock).
(2). The rate of interest determined the level of investment.
(3). The rate of interest determined the level of savings (where savings =
investment; Hicks further had savings dependent upon the level of output,
but since output gets determined by the first formula, Hicks (1937),
therefore asserts: "we do not need to bother about inserting income here
unless we choose").
The first formula determines total output-and-employment; where the total
employment represented by the 'sum' of the number of workers needed to produce
investment output, combined with the number needed to produce consumption
output, so if labor productivities differ between the 2 sectors then the
breakdown has to become known before total employment becomes determined;
whereupon if the savings rate increases, then so does investment. Increasing
money wages, as Hicks asserts: "will necessarily diminish employment and raise
real wages", while the obverse policy, of cutting money wages, will necessarily
increase employment while reduce the real-wage. Decreasing the money supply
directly decreases income-and-employment, thus the main explanation for economic
downturns; an argument later revived by Friedman.
i
IS
0
LL
I
Figure 9.
John Hicks' (1937) IS-LM model of John Keynes Economic Theory.
Clearly though Keynes' theory was nothing like this, yet Hicks went on to
'summarize' Keynes by 3 more formulae:
(1). The demand for money depends upon the rate of interest (in place of the
classical fixed relationship between money-and-output).
(2). Investment involves a function of the rate of interest.
(3). Savings involves a function of income.
Hicks had only ignored uncertainty, expectations, liquidity preference,
determining the rate of interest, speculative capital asset prices, etc. With
the above formulae, Hicks argued that Keynes, according to the first formula
omitted the impact of income on demand for money. This involved the
"traditional demand for money" argument that some level of money becomes
required to finance everyday transactions, so that the increase in income would
generate an income in the demand for money. Hicks argued that to become truly
general the General Theory should include the impact of income on the demand for
money, aswell as the impact of the rate of interest.
Though Keynes had omitted discussion of the transactions demand for
money, because this demand appeared relatively stable, therefore less important
than the demand set by liquidity preference, but Hicks believed that "however
much stress we lay upon the “speculative motive”, the “transactions motive” must
always come in as well". So Hicks proposed a revised set of formulae in which
the demand for money depends upon 2 variables: the rate of interest, with the
level of income, though not as Keynes (1937) had it on: "the degree of our
distrust of our own calculations and conventions concerning the future".
Infact, Hicks' IS-LM curves, represented the old intersecting demand
rises, price's drop curves; but now where demand-and-supply curves represent
micro-economics, the IS-LM curves represent the macro-economic level.
A problem with Hicks' General Theory, involved the conclusions, which
many could not be derived from, not surprising since this model omitted Keynes
key 'concepts' of uncertainty-and-expectations. However, Hicks had an apparent
dilemma:
"But if this is the real 'General Theory', how does Mr. Keynes come to
make his remarks about an increase to the inducement to invest not raising the
rate of interest? It would appear from our diagram that a rise in the marginalefficiency-of-capital schedule must raise the curve IS; and, therefore, although
it will raise income and employment, it will also raise the rate of interest".
To Keynes, the reason why an increased desire to invest would not
necessarily raise the rate of interest, involves that the latter becomes
determined by the liquidity preference, which as Keynes asserts: "is a barometer
of the degree of our distrust of our own calculations and conventions concerning
the future". Thus in depressed economy, an increase in investment could well
reduce the degree of distrust, leading to a fall in the rate of interest rather
than a rise. However, Hicks' redaction of Keynes, rid of uncertainty,
conventions, expectations, etc., there were no such mechanisms to draw upon.
But fortunately, Hicks' model provided a simple-and-conventional solution:
simply bend the curves:
"This brings us to what, from many points of view, is the most
important thing in Mr. Keynes's book. It is not only possible to show that a
given supply of money determines a certain relation between Income and interest
(which we have expressed by the curve LL); it is also possible to say something
about the shape of the curve. It will probably tend to be nearly horizontal on
the left, and nearly vertical on the right. This is because there is (1) some
minimum below which the rate of interest is unlikely to go, and (though Mr.
Keynes dose not stress this) there is (2) a maximum to the level of income which
can possibly be financed with a given amount of money. If we like we can think
of the curve as approaching these limits asymptotically".
This 'liquidity trap' enabled Hicks to provide an explanation for the Great
Depression, while together reconciling Keynes with the classical economists;
hence Keynes got assigned to one end of the LM curve, where the liquidity trap
applied, while the classical; economists to the other, where full employment
appeared the rule. In the classical range of the LM curve, conventional
economics reigned supreme: there occurred a maximal, full employment level of
income, where any attempts to increase output would simply involve the causal
rising interest rate, otherwise inflation, in extensions of the IS-LM model. In
the Keynesian region, monetary policy (which moved the LM curve) remains
ineffective, because the LM curve effectively remained horizontal, but the
fiscal policy (which moved the IS curve) could generate greater output, hence
employment, without increasing interest rates. A higher level of government
expenditure could shift the IS curve to the right, hence moving the point of
intersection of the IS-and-LM curves to the right, thus raising the equilibrium
level of output. Hicks, makes the point pithily; in the Keynesian region of his
model, a depression can ensue because traditional monetary policy is
ineffective, but Keynes' prescription of fiscal policy can save the day: "So the
General Theory of Employment is the economics of Depression".
Hicks next proposed that, for reasons of mathematical elegance rather
than economic relevance, 'all' 3 variables (demand for money, investment,
savings), should become functions of both income, along with the rate of
interest (though not uncertainty nor expectations):
"In order to elucidate the relation between Mr. Keynes and the
'Classics', we have invented a little apparatus. It does not appear that we
have exhausted the uses of that apparatus, so let us conclude by giving it a
little run on its own.
With that apparatus at our disposal, we are no longer obliged to make
certain simplifications which Mr. Keynes makes in his exposition. We can
reinsert the missing I in the third equation, and allow for any possible effect
of the rate of interest upon saving; and, what is much more important, we can
call in question the sole dependence of investment upon the rate of interest,
which looks rather suspicious in the second equation. Mathematical elegance
would suggest that we ought to have I and i in all three equations, if the
theory is to be really General".
Hicks' false critical insight about the IS-LM model came far too late to
stop the revisionist juggernaut he had set in motion by re-interpreting Keynes
as Walrasian back in 1937; when his recantation in 1981, economists if aware of
his argument at 'all', ignored him, probably putting his views down to
approaching senility rather than to any blinding 'logical' revelation. In any
case, with the gradual demolition of IS-LM by economists had advanced too far by
1980. This demolition had begun in the 1950s with the strong reductionist
critique that Hicks' Keynesian model did not have good Micro-economic
foundations, by which neo-classical economists meant that it was not possible to
derive results that IS-LM could generate, such as the economy settling into a
less than full-employment equilibrium, from Standard Micro-economics. Ofcourse,
in making this critique the neo-classical economists were profoundly ignorant of
the aggregation errors in Hicks' theory. Whereas a macro-economic model derived
from Neo-classical foundations would probably become more chaotic than the
'real' world itself, even without introducing the complications the Neoclassical model omits by improperly excluding money-and-debt from the
'analysis'. However, the neo-classicalist's continued to erode away at the ISLM model, aswell as the cousin, AS-AD (Aggregate Supply-Aggregate Demand) model,
even at the many defenders of these models; to the bemused horror-andconsternation of these non-orthodox economists, whom aware of the issues,
watched as the bastardization of Keynes' 'analysis', became further emasculated.
Robert Lucas represented one these mis-guided souls, who asserted himself
a Keynesian; 20 years after Hicks had got it wrong, Lucas admitted that "if it
wasn't for Hicks", himself along with fellow Nobel Laureate Gary Becker "never
would have made any sense out of that damn book".
Though starting from the false belief that Hicks had accurately
'summarized' Keynes, Lucas then played a crucial role in undermining IS-LM
'analysis' in the early 1970s, first with the development of Rational
Expectation Macro-economics, then with what became known as The Lucas Critique,
an attack on using numerical macro-economic models as a guide to policy. These
developments led to the final overthrow of any aspect of Hicksian, let alone
Keynesian 'thought' from mainstream macro-economics. In the ultimate fulfilment
of the program of 'reductionism', Macro-economics became reduced to no more than
applied Micro-economics.
Lucas (1972), conceded that most economists believed that the Phillips
curve accurately described the trade-off society faced between inflation-andunemployment; Lucas further conceded that the statistical evidence showed a
negative relationship between inflation-and-unemployment: "It is an observed
fact that, in U.S. time series, inflation rates and unemployment are negatively
correlated". The Phillips curve trade-off interpretation of these statistics
turned an empirical regularity into guide for policy, since the statistics
implied that unemployment-and-inflation moved in opposite directions, thus it
seemed that one government could choose the level of employment it wanted by
manipulating aggregate demand; so long as willing to tolerate the inflation rate
that accompanied it. This rule of thumb policy conclusion moreover appeared
consistent with the results of the large-scale econometric models derived from
Hicks' IS-LM model.
However, Lucas remained sceptical, arguing instead in favour of what he
termed the "Natural Rate Hypothesis", that there was no such trade-off; instead,
that the economy had a natural rate of employment towards which it tended, while
any such attempts to increase employment above this rate would simply increase
the rate of inflation, but without altering employment. Lucas (1972), defined
this Natural Rate Hypothesis: "the hypothesis that different time paths of the
general price level will be associated with time paths of real output that do
not differ on average". Lucas' law involved a convoluted way of asserting the
pre-Great Depression Neo-classical belief that the economy tended towards
equilibrium in which relative prices remained stable, while any attempt to
increase the number of people employed would simply create inflation. However,
Lucas' problem in asserting this belief, involved evidence. Lucas had presented
his paper before the Stagflation (period of rising unemployment, rising
inflation) of the 1970s, when inflation-and-unemployment both rose together,
while the evidence of the period from 1960-70 showed a clear trade-off between
inflation-and-unemployment. Though the inflation-unemployment data at the
precise date at which Lucas (1976) spoke, had a much higher unemployment level
than had been experienced at a comparable rate of inflation in the 1960s,
shortly after he spoke (October 1970) the inflation rate plunged in an apparent
lagged 'reaction' to the rise in employment during the 1969-70 recession.
However, Lucas argued that the Phillips curve simply represented an
artefact of how "agents form and respond to price and wage expectations", that
attempting to exploit this curve for policy reasons would destroy the apparent
trade-off, because agents would change their expectations: "The main source of
this scepticism is the notion that the observed Phillips curve results from the
way agents form and respond to price and wage expectations, and that attempts to
move along the curve to increase output may be frustrated by changes in
expectations that shift the curve".
Nonetheless, Lucas' argument was not new, Friedman (1968) had made a
similar assertion 2 years earlier, using what became known as "Adaptive
Expectations" (Friedman, 1971). However, Milton's model was not enough for
Lucas.
Ben Bernanke (2002), given the nick-name "Helicopter Ben", for his
observation that a deflation could 'always' become reversed by the government
printing money:
"...the U.S. government has a technology, called a printing press,
that allows it to produce as many U.S. dollars as it wishes at essentially no
cost. By increasing the number of U.S. dollars in circulation under a fiat
(that is paper) money system, a government should always be able to generate
increased nominal spending and inflation...and sufficient injections of money
will ultimately always reverse a deflation".
Figure 10.
Unemployment Inflation Data in the USA., 1960-70.
However, the Helicopter part of the nick-name alluded to the work of Bernanke's
mentor, Friedman, who more than any other neo-classical economist remained
responsible for the overthrow of the IS-LM model, with a resurgent Neo-classical
orthodoxy.
A fundamental aspect of the Neo-classical model involves the
premise known as Money Neutrality: that the nominal quantity of money has no
affect on the real performance of the macro-economy, apart from causing
inflation. However, though Friedman (1969) did reassert that belief, he further
stated the condition required for it to operate in 'reality': if the quantity of
money in circulation increased by some factor, then 'all' nominal quantities
including the level of debts moreover increased by the 'same' factor:
"It is a commonplace of monetary theory that nothing is so unimportant
as the quantity of money expected in terms of the nominal monetary unit –
dollars, or pounds, or pesos. Let the unit of account be changed from dollars
to cents; that will multiply the quantity of money by 100, but have no other
effect. Similarly, let the number of dollars in existence be multiplied by 100;
that, too, will have no other essential effect, provided that all other
magnitudes (prices of goods and services, and quantities of other assets and
liabilities that are expressed in nominal terms) are also multiplied by 100".
This conclusion is so not fulfilled in 'reality', such that the opposite
conclusion therefore applies: since the value of assets, liabilities, etc., are
not adjusted when inflation occurs, therefore the nominal quantity of money in
circulation remains important. However, Friedman, who had given the assumptions
do not matter (methodological madness!), continues on as if it did not matter
that this condition was not fulfilled in 'reality'.
Friedman's next false-to-facts assertion involved that, left to their own
devices, a free-market economy with no growth, while with a constant stock of
money would settle into an equilibrium in which supply = demand in 'all'
markets, while that 'all' resources including labor remained fully employed
(where full employment becomes defined as supply = demand at the equilibrium
real-wage): "Let us suppose that these conditions have been in existence long
enough for the society to have reached a state of equilibrium. Relative prices
are determined by the solution of a system of Walrasian equations".
Ofcourse, an economy without growth has not occurred, but Friedman extended this
belief in the economy lending to full-employment equilibrium over to his model
with growth, whereupon he had the 'same' views about the actual economy.
Friedman then considers what would happen to money prices in such a
situation if there occurred a sudden increase in money supply: "Let us suppose
now that one day a helicopter flies over this community and drops an additional
$1,000 in bills from the sky, which is, of course, hastily collected by members
of the community. Let us suppose further that everyone is convinced that this
is unique event which will never be repeated".
Friedman's helicopter parable, represents the functioning of the Central Bank
(which is not a market actor) that injects money into the system, though during
a Great Recession, rather than with an economy in equilibrium.
However, Friedman with his simplistic model of money creation decided
that the consequence of doubling the money supply would ultimately double the
nominal prices. While relative prices, real output, etc., would remain
unaffected in the long-run, but with an important qualification compared to
Lucas' later 'analysis', whereupon Friedman conceded that in the interim there
could develop disturbances to relative prices, the levels of output, aswell as
employment:
"It is much harder to say anything about the transition. To begin
with, some producers may be slow to adjust their prices and may let themselves
be induced to produce more for the market at the expense of non-market uses of
resources. Others may try to make spending exceed receipts by taking a vacation
from production for the market. Hence, measured income at initial nominal
prices may either rise or fall during the transition. Similarly, some prices
may adjust more rapidly than others, so relative prices and quantities may be
affected. There might be overshooting and, as a result, a cyclical adjustment".
Friedman then extended this one-off 'thought' experiment to a theory of
inflation by assuming that this helicopter drop of money becomes a continuous
process:
"Let us now complicate our example by supposing that the dropping of
money, instead of being a unique, miraculous event, becomes a continuous
process, which, perhaps after a lag, becomes fully anticipated by everyone.
Money rains down from heaven at a rate which produces a steady increase in the
quantity of money, let us say, of 10 per cent per year".
The high-lighted phrase in the above quote, refers to what Friedman termed
Adaptive Expectations: people form expectations of what will happen in the
future based upon experience of what has happened in the recent past. Friedman
furthermore considered that there could occur disturbances in the short-term in
this new situation of a permanent 10% per annum increase in the money supply:
"If individuals did not respond instantaneously, or if there were
frictions, the situation would be different during a transitory period. The
state of affairs just described would emerge finally when individuals succeeded
in restoring and maintaining initial real balances".
However, in the long-run, these disturbances dissipate, whereby the
economy settles into a long-run equilibrium where 'all' 'real magnitudes'
(relative prices, output, employment) become the 'same' as before, but the
'absolute' price level rises at 10% per annum. This occurs not because markets
remain in equilibrium with demand exceeding supply, causing prices to rise, but
because the expectations of 'all' agents have formed that prices 'always' rise
by 10% per annum. Thus for Friedman, these expectations become causal for
prices to rise, rather than dis-equilibrium: "One natural question to ask about
this final situation is, “What raises the price level, if at all points markets
are cleared and real magnitudes are stable?” The answer is, “Because everyone
confidently anticipates that prices will rise”".
This involves Friedman's argument against Keynesian demand-management
policies, which attempted to exploit the apparent negative relationship between
unemployment, to that of the rate of inflation: though a higher rate of growth
of the money supply could in the transition become causal in employment to rise,
but ultimately the economy would return to a equilibrium level of employment,
but at a higher rate of inflation. This could become characterized as the
short-run Phillips curve moving outwards, the temporary trade-off between higher
inflation, with lower unemployment in the transition involved higher-and-higher
levels of inflation for the 'same' level of unemployment, while the long-run
Phillips curve goes vertical at the long-run equilibrium level of unemployment.
Though Friedman's Monetarist model remained highly simplistic, his
vigorous promotion of his theories which just preceded the outbreak of
stagflation during the 1970s, gave him apparent vindication; where there did
seem an outward movement of the negative relationship between unemployment-andinflation, while there appeared a long-run rate of unemployment the economy kept
tending towards, at about 6% rate of unemployment compared to the level of below
4% achieved in the 1960s.
However, Friedman the father of Monetarism, had made one falsifiable
premise that "inflation is caused by the government increasing the money supply
faster than the rate of growth of the economy", implied that to reduce
inflation, the government had to increase the money supply more slowly than the
economy grew. This had become the basis of the economist policies of Margaret
Thatcher, yet eventually this approach got abandoned; one reason, that the
government was never able to meet their targets for the rate of growth of the
money supply, the government might aim to increase the money supply by 6%, only
to see inflation grow to 11%. Moreover, the relationship between the 3 crucial
variables in Friedman's theory: the rate of inflation, the rate of growth of the
economy, with the rate of growth of the money supply, was never water-tight in
practice as it appeared on paper. This lead to the demise of Friedman's
Monetarism, though Friedman-and-followers, continued to promote his theory,
along with the premise, that "inflation is caused by the government increasing
the money supply faster than the rate of growth of the economy", arguing that
'all' sorts of attenuating circumstances disturbed the results.
Nevertheless for Lucas, the problem of Monetarism, involved Friedman's
admission that in the short-term, a boost to the money supply could have 'real
effects'. Lucas (1972) began by stating the paradox, for a neo-classical
economist, that in Neo-classical theory that there should be no relationship
between inflation-and-employment: changes in aggregate demand caused by changes
in the money supply should simply alter the price level while leaving supply
unchanged:
"It is natural (to an economist) to view the cyclical correlation
between real output and prices as arising from a volatile aggregate demand
schedule that traces out a relatively stable, upward-sloping supply curve. This
point of departure leads to something of a paradox, since the absence of money
illusion on the part of firms and consumers appears to imply a vertical
aggregate supply schedule, which in turn implies that aggregate demand
fluctuations of a purely nominal nature should lead to price fluctuations only".
Lucas' (1976) comment about money illusion, involves a criticism upon Friedman's
macro-economics as not sufficiently based on Neo-classical Micro-economic
theory; since micro-economics predicted that changing 'all' prices-and-incomes
would not affect the output decision of a single consumer, macro-economics had
to conclude that the aggregate rate of unemployment could not be altered by
monetary means:
"On the contrary, as soon as Phelps and others made the first serious
attempts to rationalize the apparent trade-off in modern theoretical terms, the
zero-degree homogeneity of demand and supply functions was re-discovered in this
new context (as Friedman predicted it would be) and re-named the 'natural rate
hypothesis'".
After discussing models used to explain the perceived inflation-unemployment
trade-off based on adaptive expectations, Lucas (1972), had observed that under
adaptive expectations, it appeared possible that actual inflation (driven by the
actual rate of growth of the money supply at a given 'time') might differ from
expected inflation (based on people's experience of past inflation that adjusted
after a lag to the current rate of inflation); this in turn would mean that, if
actual inflation exceeded expected inflation, then there could occur "unlimited
'real' output gains from a well-chosen inflationary policy. Even a once-andfor-'all' price increase, while yielding no output expansion in the limit, will
induce increased output over the (infinity of) transition periods. Moreover, a
sustained inflation will yield a permanently increased level of output".
But herein lies the dilemma: Lucas' 'logic' had revealed that the only
way to conclude that there occurred a natural rate of employment entailed
assuming that expected inflation 'always' = actual inflation, which in turn
entails assuming that people can accurately predict the future. Obviously Lucas
could not assume this, though his method of stating this obtuse, nonetheless
unmistakable:
"In the preceding section, the hypothesis of adaptive expectations was
rejected as a component of the natural rate hypothesis on the grounds that,
under some policy (the gap between actual and expected inflation) is non-zero.
If the impossibility of a non-zero value...is taken as an essential feature of
the actual rate theory, one is led simply to adding the assumption that (the gap
between actual and expected inflation) is zero as an additional axiom".
Where such an axiom is transparently non-sense, but Lucas instead immediately
goes on to state this axiom in an equivalent way, but not so plainly absurd:
"...or to assume that expectations are rational in the sense of Muth".
E. Reductionism:
Thus it follows form the construction of a 'static' series into a 'moving
images' of the economy functioning as if dynamic, from the ground-up approach of
individuals to a community of such individuals, using 'linear' mathematics of
the Demand Curve, etc., the construction of a complex Marco-economic model from
a simpler Micro-economic model appeared feasible; yet grossly false.
The problem for early Neo-classical Macro-economists, involved that there
was no Micro-economic model of Macro-economics, so they developed a Neoclassical macro-model from the foundations of the Neo-classical growth model
developed by Robert Solow (1956), with Trevor Swan (2002). Whereupon they
interpreted the equilibrium growth path of the economy as determined by the
consumption-and-leisure preferences of a representative consumer, while
explaining deviations from equilibrium, which the rest of us know as the
business-cycle, by unpredictable shocks to technology-and-consumer preferences.
This resulted in a model of the macro-economy as consisting of a single
consumer, who lives forever, consuming the output of the economy, which involves
a single good produced in a single firm, which the consumer both owns, aswell as
the only employee, which pays this individual both profits equivalent to the
Marginal Product of Capital, along with a wage equivalent to the marginal
product of labor, with which this individual decides how much labor to supply by
solving a utility function that maximizes the utility over an infinite 'time'
horizon, which the individual 'rationally' expects, therefore correctly
predicts. The economy thus would 'always' remain in equilibrium except for the
impact of unexpected technology shocks that change the firm's productive
capabilities (otherwise the individual's consumption preferences) working hours.
Any reduction in working hours equates to a voluntary act, so the Representative
Agent is never involuntarily unemployed, instead just taking more leisure.
Where there are no banks, hence no debt, thus no money in this model.
Solow's (2001) gives his own 'summary' of these models, initially called Real
Business Cycle models, though later morphed into Dynamic Stochastic General
Equilibrium models:
"The prototypical real-business-cycle model goes like this. There is
a single, immortal household – a representative consumer – that earns wages from
supplying labor. It also owns the single price-taking firm, so the household
receives the net income of the firm. The household takes the present and future
wage rates and present and future dividends as given, and formulates an optimal
infinite-horizon consumption-saving (and probably labour-saving) plan...The firm
looks at the same prices, and maximizes current profit by employing labor,
renting capital and producing and selling output...
In the ordinary way, an equilibrium is a sequence of inter-temporal
prices and wage rates that makes the decisions of household and firm consistent
with each other. This is nothing but the neoclassical growth model...
The theory actually imagines that the model economy is disturbed from
time to time by unforeseeable shocks to the technology and the household's
tastes...There is thus nothing pathological or remediable about observed
fluctuations. Unforeseeable disturbances are by definition unforeseen; after
one of them has happened, the economy is already making optimal adjustments,
given its technology and the inter-temporal preferences of its single inhabitant
or identical inhabitants. There is no role for macroeconomic policy in the
world...the best it (the government) can do is to perform its necessary
functions in the most regular, predictable way, so as not to add unnecessary
variance to the environment".
Though Micro-economics masquerading as Macro-economics took over PhD programs
across the US., there remains opposition to this approach to macro-economics
from within the Neo-classical school itself, including Solow.
F. Econo-Physics Of Complexity:
The Econo-physics (Greek oikonomikos from oikonomin, to manage a household:
concerned with functional processes of wealth; Greek phusikē, of nature) has
largely subsumed the Complexity Theory approach; the notion of chaos first
became discovered in 1899 (even before Edward Norton Lorenz, 1979), by Jules
Henri Poincaré (1854-1912, French physicist), who had tried to develop a formula
describing planetary motion in a system with more than one planet (Isaac
Newton's (1642/43-1727), assumption, in order to derive an initial theory,
involved a Solar system which only consisted of the Sun, along with the Earth,
which gave rise to the theory that planets follow elliptical orbits), came to a
proof that there was no such formula, since the actual orbits 'interact' in
wildly unpredictable ways, as the Solar system evolved to the present structural
configuration. However, the true implications were not fully explored until the
1960s, after the invention of the computer. Complexity involves non-linear
relationships between components of a system, whereupon they have the ability to
"Self-Organize". Edward Norton Lorenz's (1979, etc) model, describes the nonlinear relations between displacement-and-temperature (shown in terms of a
graph), generates 'behavior' which though on the surface appears chaotic,
demonstrates the organizing force of the "Strange Attractor".
In 1979, Edward Lorenz developed a simplified mathematical model for
atmospheric convection. The model involves a system of 3 ordinary differential
equations now known as the Lorenz equations:
x
 = (y-x)
t
Equation 7.
y
 = x(p-z)
t
Equation 8.
z
 = xy-z
t
Equation 9.
where x,y,z, Make up the system 'state'.
t, 'Time'.
,,p, System parameters.
The first formula (x), described the intensity of convective motion, the second
formula (y), the temperature difference between ascending-and-descending columns
of air, the third formula (z), described the divergence from 'linearity' of the
temperature gradient across the weather cell.
Economic Complexity theory is not so much a school of 'thought' in
Economics as a group of economists who apply what became known as Chaos Theory
to economic issues. However, since complexity theorists have argued that
economy demonstrates similar characteristics; early proponents include that of
Richard Goodwin (1990, 1991), Benoît Mandelbrot (1971, 2005), Hans-Walter Lorenz
(1987, 1989), etc. The future of Economics as a Science lies with
non-elementalism, hence especially Complexity theory.
Figure 11.
Structure behind the chaos, the Strange Attractor: the butterfly wings.
Where z, Co-ordinates shows the Temperature Gradient.
x,y, Co-ordinates of displacement.
After Edward Norton Lorenz (1969), mathematical model of turbulent flow.
The Omission Of Debt Variable:
Paul Krugman (2010), with G.B. Eggertsson, acknowledges that Neo-classical
macro-economic modeling before the Financial Crisis, had not even considered the
consequences of private debt: "If there is a single word that appears most
frequently in most discussions of the economic problems now afflicting both the
United States and Europe, that word is surely 'debt'". Krugman with Eggertsson
continue:
"Given both the prominence of debt in popular discussion of our
current economic difficulties and the long tradition of invoking debt as key
factor in major economic contraction, one might have expected debt to be at the
heart of most mainstream macroeconomic models – especially the analysis of
monetary and fiscal policy. Perhaps somewhat surprisingly, however, it is quite
common to abstract altogether from this feature of the economy. Even economics
trying to analyse the problem of monetary and fiscal policy at the zero lower
bound – and yes, that includes the authors – have often adopted representativeagent models in which everyone is alike, and in which the shock that pushes the
economy into a situation in which even a zero interest rate isn't low enough
takes the form of a shift in everyone's preferences".
This along with the unnecessary insistence on equilibrium modeling perhaps
involves the vital weakness in Neo-classical economics: since with the omission
of debt, a crucial variable in the 'analysis' of a market-economy, then one can
get nothing else right.
However, Krugman despite the above, made no fundamental shift from a Neoclassical approach; he only modified his base New Keynesian model to incorporate
debt as he perceived it; consequently Krugman fell into fell into the trap that
Bernanke had, of being incapable of conceiving that aggregate debt can have a
macro-economic impact: "Ignoring the foreign component, or looking at the world
as a whole, the overall level of debt makes no difference to aggregate net worth
– one person's liability is another person's asset". With this one statement,
Krugman showed that he had failed to comprehend Minsky, who had realized, as did
Schumpeter, along with Marx before him, that growing debt in fact boosts
aggregate demand; as Minsky (1982) asserts:
"If income is to grow, the financial markets...must generate an
aggregate demand that, aside from brief intervals, is ever rising. For real
aggregate demand to be increasing...it is necessary that current spending plans,
summed over all sectors, be greater than current received income...It follows
that over a period during which economic growth takes place, at least some
sectors finance a part of their spending by emitting debt or selling assets".
Krugman further has no understanding of the endogeneity of credit money:
that banks create an increase in spending power by together creating money-anddebt. Lacking any appreciation of how money is created in a credit-based
economy, Krugman instead sees lending as simply a transfer of spending-power
from one agent to another, where neither banks nor money occurs in his model.
Instead of modeling the economy as single representative agent, Krugman modeled
it as consisting of 2 agents, one of whom impatient, while the other patient;
whereupon debt simply involved the transfer of spending-power from the patient
to the impatient agent, whereby the debt itself had no macro-economic impact;
thus debt simply involved the transferring of spending-power from one agent to
other. However, the only way this model could have a macro-economic impact,
involved that if the impatient agent became somehow constrained in ways that the
patient agent was not, as Krugman asserts: "In what follows, we begin by setting
out a flexible-price endowment model in which “impatient” agents borrow from
“patient” agents (when what is borrowed is not money, but “risk-free bonds
denominated in the consumption good”), but are subject to a debt limit".
So, in order to generate a crisis, Krugman with Eggertsson had to
introduce an ad hoc, unexplained change to this debt limit:
"If this debt limit is, for some reason, suddenly, reduced, the
impatient agents are forced to cut spending; if the required deleveraging is
large enough, the result can easily be to push the economy up against the zero
lower bound. If debt takes the form of nominal obligations, Fisherian debt
deflation magnifies the effect of the initial shock".
Krugman then generalized this with "a sticky-price model in which the
deleveraging shock affects output instead of, or as well as, prices", brought in
nominal prices without money by imagining "that there is a nominal government
debt traded in zero supply...We need not explicitly introduce the money supply",
modelled production; where Krugman's preceding 'analysis' involved a nonproduction economy in which agents simply trade 'existing' endowments of goods
distributed like manna from heaven, under imperfect competition, then included a
Central Bank that sets the interest rate (in an economy without money) by
following a Taylor Rule (after John Taylor, 2007; refer to Appendix: The Taylor
Rule), etc. However, with the wrong mathematics, Krugman's model ended up
comparing 2 equilibria separated by 'time', whereas a truly dynamic 'analysis'
would consider change over 'time' regardless of whether equilibrium applies-ornot.
The Theory Of Value:
The premise that something represents a source of value raises 2 questions:
(1). What constitutes value?
(2). Why should something have value?
A generic definition of value (Latin valēre, of worth), which economists use,
represents value as an 'innate' worth which a commodity has, which determines
the 'normal' (equilibrium) ratio at which commodities exchange; an important
corollary to this, that value is unrelated to the 'subjective' valuation which
purchasers put upon a product.
Classical economists moreover use the terms value in use (use-value),
value in exchange (exchange-value), to distinguish between 2 fundamental aspects
of a commodity: usefulness, along with the effort involved in producing it.
Value in use represents a fundamental aspect of a commodity (why buy something
useless?), but for classical economists it played no role in determining price.
Their 'concept' of usefulness they took as 'objective', focusing upon the
commodity's actual function rather than how it affected the user's 'feelings' of
well-being; for example, the use-value of a chair was not how comfortable it
made you 'feel', but that you could sit in it.
The Neo-classical school in contrast, argued that value, like beauty,
remains "in the eye of the beholder", that utility in even equilibrium, has to
reflect the 'subjective' value in price, put upon the product by both the buyerand-seller; Neo-classical economics argues that the equilibrium ratio at which 2
products exchange becomes determined by the ratio of their marginal utilities to
their marginal costs. Economists like Keen, though admits that there are
serious problems with pricing, nonetheless, he argues that it seems reasonable
to say that price should become determined by both the 'innate' worth of a
product, however defined, combined by the buyer's 'subjective' valuation of it.
The general classical reply to this 'concept', involved that in the short-term,
further out of equilibrium, that would appear true, but in the long-term,
prices, moreover the prices of things which could easily become reproduced,
would become determined by the value of the product, not by the 'subjective'
valuations of the buyer-or-seller. For this reason, the Classical school tended
to distinguish between price-and-value, to use the former when they talked about
day-to-day sales, which could involve prices which appeared above-or-below longrun values. Aswell as having some influence out of equilibrium, 'subjective'
utility represented the only factor that could determine the value of rare
objects. As David Ricardo (1817) asserted:
"There are some commodities, the value of which is determined by their
scarcity alone. No labour can increase the quantity of such goods, and
therefore their value cannot be lowered by an increased supply. Some rare
statues and pictures, scarce books and coins, wines of a peculiar quality, which
can be made only from grapes on a particular soil, of which there is a very
limited quantity, are all of this description. Their value is wholly
independent of the quantity of labour originally necessary to produce then, and
varies with the varying wealth and inclinations of those who are desirous to
possess them".
Thus where scarcity appears the rule, furthermore where the objects sold
could not easily become reproduced, price becomes determined by the seller-andbuyer's 'subjective' utilities; however, this minority of products was ignored
by the classical economists. Marx gave a further explanation as to why, since
in a developed 'Capitalist' economy, the 'subjectiv' valuations of both buyerand-seller would be irrelevant to the price at which commodities exchanged. For
Marx, aswell as the classical economists, this 'subjectivity' involved an
historic argument: in the distant past, humans lived in small, relatively
isolated communities, where exchange between them, represented a rare, isolated
event. At this stage, objects getting exchanged would involve items that one
community could produce but the other could not. Thus one community would have
no idea how much effort had gone into the making of the product, so the sole
basis for deciding how to exchange one product for another involved a
'subjective' valuation. As Marx (1867) asserted:
"The exchange of commodities, therefore, first begins on the
boundaries of such communities, at their points of contact with other similar
communities, or with members of the latter. So soon, however, as products once
become commodities in the external relations of a community, they also, by
reaction, become so in its internal intercourse. The proportions in which they
are exchangeable are at first quite a matter of chance. What makes them
exchangeable is the mutual desire of their owners to alienate them. Meantime
the need for foreign objects of utility gradually establishes itself. The
constant repetition of exchange makes it a normal social act. In the course of
time, therefore, some portion at least of the products of labour must be
produced with a special view to exchange. From that moment the distinction
becomes firmly established between the utility of an object for the purpose of
consumption, and its utility for the purposes of exchange. Its use-value
becomes distinguished from its exchange-value. On the other hand, the
quantitative proportion in which the articles are exchangeable, becomes
dependent on their production itself".
Perhaps the most famous example, involves the alleged exchange of the
Island of Manhattan for a bunch of beads, between the Dutch-and-Indians.
Whereupon in an advanced capitalist nation, factories churn out mass quantities
of products especially for exchange, where the seller has no interest in the
products their factory produces; the sale price reflects the cost of production,
where the 'subjective' utility of the buyer-and-seller irrelevant to the price.
There appears thus a prima facie plausibility to the argument that value alone
determines the equilibrium ratio at which commodities become exchanged.
However, the problem comes with the second question (raised from above): why
should something have value?
The first economists to consider this question, answered that the source
of 'all' value comes from the land. A simple argument put forward for this
might go: land 'existed' before humans, therefore humanity's labor, could not be
the source of value, value had to have come from the land as it absorbed the
energy from the Sun; thus human labor simply took the naturally generated wealth
of the land, transformed into a different form. Whereupon since land generated
a surplus, else net product, so this enabled both growth, aswell as
discretionary spending to occur. Manufacturing, since sterile, it simply took
whatever value the land had given, transforming it into different commodities of
an equivalent value. No formal proof given however, beyond the appeal to
observation, for example as given by Quesnay (in R. Meek, 1972):
"Maxims of Economic Government. I: Industrial work does not increase
wealth. Agricultural work compensates for the costs involved, pays for the
manual labor employed in cultivation, provides gains for the husbandmen, and, in
addition, produces the revenue of landed property. Those who buy industrial
goods pay the costs, the manual labor, and the gain accruing to the merchants;
but these goods do not produce any revenue over and above this. Thus all the
expenses involved in making industrial goods are simply drawn from the revenue
of landed property – no increase of wealth occurs in the production of
industrial goods, since the value of these goods increases only by the cost of
the subsistence which the workers consume".
Thus if land determined the value of commodities, while the price paid
for something ordinarily taken as equivalent to the value, the ratio between the
prices of 2 commodities should appear equivalent to the ratios of the land
needed to produce them.
This physiocratic answer to the source of value, betrays the Classical
school's origins in rural France. However Smith (1776), though strongly
influenced by the physiocrats, in the "Wealth Of Nations" (published in the year
that the first steam engine became installed) argued that labor represented the
source for value: "The annual labour of every nation is the land which
originally supplies it with all the necessaries and conveniences of life which
annually consumes, and which consist always either in the immediate produce of
that labour, or what is purchased with that produce from other nations". The
growth of wealth represented the division of labor, which increased because the
expansion of industry allowed each job to become divided into ever smaller
specialized sub-tasks. This then allowed what economists call economies of
scale: an increase in the size of the market allowed each firm to make work more
specialized, thus lowering production costs, which Smith's famous example,
involved the pin factory.
Smith therefore had an explanation for the enormous growth which occurred
during the Industrial Revolution. However, there remained a dilemma for Smith,
though he knew that labor provided the source for value, it could not possibly
determine price; yet the value remained supposed to determine the ratio at which
2 commodities exchanged. The dilemma arose because 2 commodities could exchange
only on the basis of the amount of direct labor involved in their manufacture if
only labor remained required for their production. Smith gave for his example
of exchange, a primitive hunting society:
"In that early and rude state of society which precedes both the
accumulation of stock and the appropriation of land, the proportion between the
quantities of labour necessary for acquiring objects seems to be the only
circumstance which can afford any rule for exchanging them for one another. If
among a nation of hunters, for example, it usually costs twice the labour to
kill a beaver which it does to kill a deer, one beaver should naturally exchange
for or be worth two deer".
However, once there involved an accumulation of stock, once a market-economy had
evolved, then paying for the labor alone was not sufficient; the price had to
further cover profit, as Smith continues:
"As soon as stock has accumulated in the hands of particular persons,
some of them will naturally employ it in setting to work industrious people,
whom they will supply with materials and subsistence, in order to make a profit
by the sale of their work, or by what their labour adds to the value of the
materials. In exchanging the complete manufacture either for the money, for
labour, or for other goods, over and above what may be sufficient to pay the
price of materials, and the wages of the workmen, something must be given for
the profits of the undertaker of the work who hazards his stock in this
adventure".
So Smith had to concede that the price had to become high enough to pay
not just for the hours of labor involved in making something, but moreover a
profit. Using an example of a deer hunter, who in employ of a deer-hunting
firm, thence the price of the Deer had to cover the hunter's labor, moreover a
profit margin for the firm.
The problem became even more complicated when we consider land. Now the
price had to cover labor, profit, along with rent; as Smith asserted: "As soon
as the land of any country has all become private property, the landlords, like
all other men, love to reap where they never sowed, and demand a rent even for
its natural produce".
Thus in the end, Smith reduced this argument into an 'adding up' theory
of prices: the price of a commodity represented in part-payment for labor, in
part-payment for profit, further in part-payment for rent; where there was no
strict relationship between value-and-price.
Ricardo (1817) shared this belief with Smith that labor determined the
value of a commodity: "The value of a commodity, or the quantity of any other
commodity for which it will exchange, depends on the relative quantity of labor
which is necessary for its production". However, Ricardo became more concerned
for the need for precise definitions, aswell as the difficulties in going from
value to price.
Smith had used 2 measures of the amount of labor contained in a product:
"Labour embodied", related to "Labour commanded". Labour embodied represented
the amount of direct labor-time it actually took to make a commodity; Labour
commanded represented the amount of labor-time one could buy using that
commodity. If for example, it took 1 day for a labourer to make a chair, then
the chair embodied 1 day's labor. However, that chair could well sell for an
amount equivalent to 2 days' wages, with the difference accounted for by profitand-rent. Ricardo believed, as did most classical economists, that workers
received a subsistence wage, since this would 'always' have equivalence to a
fairly basic set of commodities, such as so much food, clothing, aswell as
rental accommodation; which should not change much from one year to the next.
The latter measure however, reflected the profit earned by selling the worker's
output, which instead should vary enormously over the trade-cycle. Ricardo's
solution for this value/price dilemma, the price of a commodity included not
just direct labor, but the labor involved in producing any tools. Thence
Ricardo took Smith's deer-and-beaver example, elaborating upon it; since in
Smith's example, some equipment had to become used to kill the game, moreover
variations in the amount of 'time' it took to make the equipment would affect
the ratio in which deer-and-beavers would get exchanged:
"Even in that early state to which Adam Smith refers, some capital,
though possibly made and accumulated by the hunter himself, would be necessary
to enable him to kill his game. Without some weapon, neither the beaver nor the
deer could be destroyed, and therefore the value of these animals would be
regulated, not solely by the time and labour necessary to their destruction, but
also by the time and labour necessary for providing the hunter's capital, the
weapon, by the aid of which their destruction was effected.
Suppose the weapon necessary to kill the beaver was constructed with much
more labour than that necessary to kill the deer, on account of the greater
difficulty of approaching near to the former animal, and the consequent
necessity of its being more true to its mark; one beaver would naturally be of
more value than two deer, and precisely for this reason, that more labour would,
on the whole, be necessary to its destruction".
Thus the price of any commodity reflected the labor involved in creating it,
furthermore that labor involved in creating any means of production used up in
their manufacture. Ricardo consequently gave many examples in which the labor
involved in producing the means of production simply reappeared in the product,
whereas direct labor 'added' further value over-and-above the means of
subsistence, since the difference between labor embodied (which equaled a
subsistence wage), with labor commanded (which included a profit for the
capitalist).
Nevertheless, both Smith with Ricardo remained vague, inconsistent, etc.,
on important aspects of the theory of value. Though Smith generally argued that
labor represented the source for value, on several occasions he counted the work
of farm animals as labor; as Smith asserts: "Not only his labouring servants,
but his labouring cattle, are productive labourers". Yet though Smith failed to
account for machinery in the creation of value, he did argue that machines could
produce more value than it took to produce them, which would mean that machinery
(including animals) would become a source for value, moreover to the labor, as
Smith continues: "The expense which property laid out upon a fixed capital of
any kind, is always repaid with great profit, and increases the annual produce
by a much greater value than that of the support which such improvements
require".
Whereas Ricardo more consistently implied that a machine 'added' no more
value to output than it lost in depreciation, but he on occasion lapsed into
completely ignoring the contribution of machinery to value: "By the invention of
machinery... a million of men may produce double, or treble the amount of
riches...but they will on no account add anything to value".
Marx (1861) however quite rightly disagreed: "This is quite wrong. The
value of the product of a million men does not depend solely on their labour but
also on the value of the capital with which they work". Whereas his forebears
had remained vague, otherwise only implied, Marx (1867), instead emphatically
stated: "labour was the only source of value, in the sense that it could add
more value than it has itself". Marx called this difference between the value
embodied in a worker, to that of the value the worker 'added' to production
"Surplus value", regarding it as the sole source of profit. Marx (1861)
criticized Ricardo for not providing a systematic explanation for this
difference:
"Ricardo starts out from the actual fact of capitalist production.
The value of labour is smaller than the value o the product which it creates –
The excess of the value of the product over the value of the wages is the
surplus-value – For him, it is a fact, that the value of the product is greater
than the value of the wages. How this fact arises, remains unclear. The total
working-day is greater than that part of the working-day which is required for
the production of wages. Why? That does not emerge".
The best that Ricardo could offer, according to Marx:
"...(t)he value of labour is therefore determined by the means of
subsistence which, in a given society, are traditionally necessary for the
maintenance and reproduction of the labourers.
But why? By what law is the value of labour determined in this way?
Ricardo has in fact no answer, other than – the law of supply and demand
– He determines value here, in one of the basic propositions of the whole
system, by demand and supply – as Say notes with malicious pleasure".
Similarly Marx rejected Smith on the productivity of machinery, agreeing
with Ricardo that a machine only 'added' as much value to output as it lost
through depreciation:
"The maximum loss of value that they can suffer in the process, is
plainly limited by the amount of the original value with which they came into
the process, or in other words, by the labour-time necessary for their
production. Therefore, the means of production can never add more value to the
product than they themselves possess independently of the process in which they
assist. However useful a given kind of raw material, or a machine, or other
means of production may be, though it may cost £150, or, say 500 days' labour
yet it cannot, under any circumstances, add to the value of the product more
than £150".
Marx similarly agreed with Ricardo's definition of value (cited above),
that it "depends on the relative quantity of labour which is necessary for its
production". Thence value in turn determined the price at which commodities
exchanged, with commodities of an equivalent value, those commodities consisting
of an equivalent amount of labor (where Marx qualified this as "Socially
necessary labour-time", in order to take into account the possibility of out-ofequilibrium situations in which more labour-time might become lavished upon a
product than could become recouped by their sale), exchanging for the 'same'
price (in equilibrium).
Nonetheless this exchange of equivalents still had to enable capitalists
to make a profit, which Marx (1847) became disparaging of any explanation of
profit which had a basis on "buying cheap and selling dear":
"To explain, therefore, the general nature of profits, you must start
from the theorem that, on the average, commodities are sold at their real
values, and that profits are derived by selling them at their values, that is,
in proportion to the quantity of labour realized in them. If you cannot explain
profit upon this supposition, you cannot explain it at all".
Here on, Marx gave 2 explanations for the origin of surplus-value:
(1). Negative proof, by a process of elimination based on the unique
characteristics of labour.
(2). Positive proof, based on a general theory of commodities.
Origin Of Surplus-Value I:
Marx's first Theory of Surplus-Value, involved labor as an unique commodity, in
that what got sold was not the worker (which ofcouse involve slavery), but their
capacity to work, which Marx termed "Labour-power". Where the value (cost of
production) of labour-power represented the means of subsistence, since that
involved what it took to reproduce labour-power. Say that it took 6 hours of
labor to produce the goods needed to keep a worker alive for I day.
Figure 12.
Karl Heinrich Marx (May 5, 1818 - March 14, 1883).
However, what the capitalist actually received from the worker, in return
for paying for their labour-power, did not involve the worker's capacity to work
(labour-power), but actual work itself. If the working day involved 12 hours
(as in Marx's day), then the worker worked for 12 hours, 2x as long as it
actually took to produce their value. This further 6 hours of work thus
represented "Surplus-labour", which accrued to the capitalist, thus not the
basis of profit. As Marx asserted:
"The labourer receives means of subsistence in exchange for his
labour-power; the capitalist receives, in exchange for his means of subsistence,
labour, the productive activity of the labourer, the creative force by which the
worker not only replaces what he consumes, but also gives to the accumulated
labour a greater value than it previously possessed".
This difference between labor to that of labour-power appears entirely
unique to labor: there appeared no other commodity where a commodity with
"Commodity-power" could become distinguished. Therefore other commodities used
up in production simply transferred their value to the product, whereas labor
could become the source of more value. Surplus-value, when successfully
converted into money by the sale of commodities produced by the worker, became
in turn the source of profit.
Marx's Labour Theory Of Value: The Demise Of 'Capitalism'.
This direct causal relationship between surplus-value with that of profit,
entailed there moreover involved a direct causal relationship between what Marx
called the rate of surplus-value, with that of the rate of profit. Where the
rate of surplus-value, represented the ratio of the "Surplus labour-time",
performed by a worker to the 'time' required to reproduce the value of labourpower. With regards to our example, of 12 hours of work, the ratio becomes 1:1,
otherwise 100%: 6 hours of surplus-labour to 6 hours of what Marx termed
"Necessary labour".
Marx defined the rate of profit as the ratio of surplus (denoted with the
symbol s), to the 'sum' of the inputs required to generate the surplus. To this
2 kinds of inputs became required: necessary labour along with the "Means of
production", represented by the depreciation of fixed capital + raw materials,
intermediate goods, etc. Marc then termed necessary labour "Variable capital"
(denoted by v), since it can increase in value, whereupon he termed the means of
production used up "Constant capital" (denoted by c), since it could not
increase value. Where Marx (1867) gives:
"Let the mass of the surplus-value be S, the surplus-value supplied by
the individual labourer in the average day s, the variable capital daily
advanced in the purchase of one individual labour-power v, the sum total of the
variable capital V, the value of an average labour-power P, its degrees of
a'
surplus-labour
exploitation  () and the number of labourers employed n; we
a
necessary-labour
have:
s

x V
v
S =
a'
P x  x n
a
(Equation 10).
It is always supposed, not only that the value of an average labour-power
is constant, but that the labourers employed by a capitalist are reduced to
average labourers. There are exceptional cases in which the surplus-value
produced does not increase in proportion to the number of labourers exploited,
but then the value of the labour-power does not remain constant".
Now taking the example of weaving, which Marx used extensively, during 1
working day, a weaver might use 1,000 yards of yarn, wearing out 1 spindle in
the process. The yarn might have taken 12 hours of (direct-and-indirect) labor
to make, while the spindle a similar amount of 'time'. Thus the 'sum' of the
direct labour-time of the worker, plus the labour-time embodied in the yarn,
combined with the spindle = 36 hours: 12 hours' labor by the weaver, 12 for the
yarn, 12 for the spindle. The ratio of the surplus to c + v = 6:30 for a rate
of profit of 20%. Whereupon Marx (1867), provides various formulae for the rate
surplus-value:
"We have seen that the rate of surplus-value is represented by the
following formulae.
I.
Surplus-value
s
 = 
Variable Capital
v
Surplus-value
 
Value of labour-power
Surplus-labour

Necessary labour
The two first of these formulae represent, as a ratio of values, that which, in
the third, is represented as a ratio of the times during which those values are
produced. These formulae, supplementary the one to the other, are rigorously
definite and correct. We therefore find them substantially, but not
consciously, worked out in classical political economy. There we meet with the
following derivative formulae.
II.
Surplus-labour
Surplus-value
 = 
Working-day
Value of the Product
Surplus-product
= 
Total Product
One and the same ratio is here expressed as a ratio of labour-times, of
the values in which those labour-times are embodied, and of the products in
which those values exist. It is of course understood that, by “Value of the
Product,” is meant only the value newly created in a working-day, the constant
part of the value of the product being excluded.
In all of those formulae (II.), the actual degree of exploitation of
labour, or the rate of surplus-value, is falsely expressed. Let the working-day
be 12 hours. Then, making the same assumptions as in former instances, the real
degree of exploitation of labour will be represented in the following
proportions.
6 hours surplus-lbaour
Surplus-value of 3 sh.
 =  = 100%
6 hours necessary labour
Variable Capital of 3 sh.
From formulae II.
We get very differently,
6 hours surplus-lbaour
Surplus-value of 3 sh.
 =  = 50%
Working-day of 12 hours
Value Created of 6 sh.
These derivative formulae express, in reality, only the proportion in
which the working-day, or the value produced by it, is divided between
capitalist and labourer. If they are to be treated as direct expressions of the
degree of self-expansion of capital, the following erroneous law would hold
good: Surplus-labour or surplus-value can never reach 100%. Since the surpluslabour is only an aliquot part of the working-day, or since surplus-value is
only an aliquot part of the value created, the surplus-labour must necessarily
be always less than the working-day, or the surplus-value always less than the
total value created. In order, however, to attain the ratio of 100:100 they
must be equal. In order that the surplus-labour may absorb the whole day (i.e.,
an average day of any week or year), the necessary labour must sink to zero.
But if the necessary labour vanish, so too does the surplus-labour, since it is
Surplus-labour
Surplus-value
only a function of the former. The ratio  or 
Working-day
Value created
100
100 + x
can therefore never reach the limit of , still less rise to .
100
100
But not so the rate of surplus-value, the real degree of exploitation of
labour".
Where, Marx assumed that the ratio of surplus-value, the rate of s to v,
remains 'constant', both across industries-and-'time'. Marx then together with
this, argued that the competitive forces of 'capitalism' would lead to
capitalists replacing direct labor with machinery, so that for any given
production process, c would get bigger with 'time'. Whereby with s/v
'constant', this would decrease the ratio of s to the 'sum' of c, with v, thus
reducing the rate of profit. Leaving aside some complications, capitalists
would thus find that, regardless of their best efforts, the rate of profit will
fall; whereupon capitalists would try to drive down wage-rate, which would lead
to revolt by the politically aware working class, thus leading to a socialist
revolution.
However, there is no reason that the rate of surplus-value should remain
at 'constant' over 'time' in practice, whereupon Joan Robinson (1971) used this
as the basis of her critique of Marxian economics: she argued that an increase
in c could create a rise in s/v, the rate of surplus-value, so that the rate of
profit would not fall over 'time'. Furthermore, even if one accepted that value
represented the only source for value, Marx's theory still had major 'logical'
problems, chief amongst them, what has become known as the "Transformation
problem": capitalists are motivated not by the rate of surplus-value, but by the
rate of profit. If the rate of surplus-value remains 'constant' across
industry, while labor the only source of surplus, then industries with the
higher than average ratio of labor to capital should have a higher rate of
profit. Yet if a 'Capitalist' economy becomes competitive, this situation
cannot apply in equilibrium, since higher rates of profit in labor-intensive
industries should lead to firms moving out of capital-intensive industries into
labor-intensive ones, in search of a higher rate of profit.
Though Marx was not an equilibrium theorist, he nevertheless had to
reconcile a 'constant' rate of surplus-value across industries with at least a
tendency towards 'uniform' rates of profit; whereas Marx's treatment of such a
process of 'uniform' rates of profit (equilibrium) was not consistent. Instead
Marx's (1894) solution, involved arguing that 'Capitalism' becomes-as-a-result a
joint enterprise, where the capitalist earned a profit which became proportional
to their investment, regardless of whether they invested in a labor-intensive,
else capital-intensive industry:
"Thus, although in selling their commodities the capitalists of the
various spheres of production recover the value of the capital consumed in their
production, they do not secure the surplus-value, and consequently the profit,
created in their own sphere by the production of these commodities – So far as
profits are concerned, the various capitalists are just so many stockholders in
a stock company in which the shares of profit are uniformly divided per 100".
Another problem involved Sraffa's (1926), 'analysis' of the Economic
theory of price determination, related to income distribution. The basis of
Sraffa's system involves the acknowledgment that commodities become produced
using other commodities-and-labor. Unlike conventional economics, which has
invented the fictional abstractions of "Factors of production", Marx's system
appeared consistent with Sraffa's "Production of commodities by means of
commodities" 'analysis'. However, I. Steedman (1977), through comprehensiveand-systematic comparison using Sraffa's 'analysis', there appear serious
inconsistencies, undermining Marx's sequence of assertions that labor represents
the only source of value, that value the only source of profits, thus value
determines price. Furthermore, Marx could not provide a reason why
'Capitalism', possibly the most internally competitive social-system ever,
should ultimately function so co-operatively, with capitalists sharing in total
social profit as "just so many stockholders in a stock company in which the
shares of profit are uniformly divided per 100".
Origins Of Surplus-Value II:
Now with regards to the second origin of surplus-value, Marx had up until 1857,
had believed labor represented the source of value via the negative proof, after
which he developed an alternative far superior theory. Marx had become
entangled with Dialectical Philosophy: concerning change, which Marx derives
from Hegel (Georg Wilhelm Friedrich Hegel, 1770-1831; further derived from
Johann Gottlieb Fichte, 1762-1814), whereupon Marx had argued that he had
replaced Hegel's 'Idealism' with 'Realism'. Dialectics begins from the premise
that any 'entity' 'exists' in a social environment; where this environment will
emphasize some aspects of the 'entity', while necessarily places less emphasis
upon 'all' other aspects of the 'entity'. However, the 'entity' cannot 'exist'
without both the foreground aspects (the features the environment emphasizes),
aswell as background aspects (those ones it neglects). This sets up a tension
within the 'entity', whereas possibly between the 'entity'-and-environment.
This tension can transform the nature of the 'entity', while even the
environment itself. When Marx applied this 'logic' to the 'concept' of
commodity, reasoning that the commodity represented the unity of use-value to
that of the exchange-value. In a 'Capitalist' economy, the exchange-value of a
commodity becomes brought to the foreground; this entails that the use-value of
a commodity is irrelevant to the price: the price instead gets determined by the
exchange-value. Yet the commodity cannot 'exist' without the use-value (since
something useless cannot be a commodity), so that a dynamic tension gets set-up
between use-value, to that of the exchange-value in 'Capitalism'.
Prior to this, Marx had agreed with both Smith with Ricardo, that usevalue was irrelevant to economics, after this the 'concept' of use-value in
unison with exchange-value, became a unifying 'concept' for his whole 'analysis'
of 'Capitalism'; from Marx's (1857), first rough draft of Das Kapital: "Is not
value to be conceived as the unity of use-value and exchange-value? In and for
itself, is value as such the general form, in opposition to use-value and
exchange-value as particular forms of it? Does this have significance in
economics?", showed how novel this notion seemed to him. Marx continued to use
this positive methodology, based on a general axiomatic 'analysis' of the
commodity to explain the source of surplus-value.
Society
ForeBackGround Unity Ground
Dialectical
Tension
Figure 13.
A Graphical representation of Karl Marx's dialectics.
From Steve Keen (2011) "Debunking Economics".
As mentioned earlier, Marx had criticized Ricardo for not having an
explanation of why labour embodied differed from labour commanded; Marx then
notes that Smith fell for the fallacy that, under 'Capitalism', a worker should
become paid his full product:
"Ricardo, by contrast, avoids this fallacy, but how? “The value of
labour, and the quantity of commodity which a specific quantity of labour can
buy, are not identical”. Why not? “Because the worker's product is not = to
the worker's pay”. I.e. the identity does not exist, because a difference
exists – Value of labour is not identical with wages of labour. Because they
are different. Therefore they are not identical. This is a strange logic.
There is basically no reason for this other than it is not so in practice".
Marx then contrasts his easy ability to derive the source of surplusvalue with Ricardo's struggles:
"What the capitalist acquires through exchange is labour capacity;
this is the exchange value which he pays for. Living labour is the use-value
which this exchange value has for him, and out of this use-value springs the
surplus value and the suspension of exchange as such".
For some reason, as Keen notes, Marx's positive 'concept' of surplusvalue has become ignored by Marxists, in preference for the negative proof, it
seems for the promise of the fall of 'Capitalism'.
In Das Kapital, Marx began by clearing intellectual fuzziness to
uncovering the source of surplus, criticizing on the way, explanations based
upon unequal exchange, else increasing utility through exchange. Marx then
restated the Classical axiom that exchange involves the transfer of equivalents,
with the conclusion that therefore exchange of itself cannot provide the answer.
Yet anticipating the dilemma that circulation based on the exchange of
equivalence must involve the starting point from which the source of surplusvalue becomes 'deduced', as Marx (1867) asserts:
"The conversion of money into capital has to be explained on the basis
of the laws that regulate the exchange of commodities, in such a way that the
starting point is the exchange of equivalents. Our friend, Moneybags, who as
yet is only an embryo capitalist, must buy his commodities at their value, must
sell them at their value, and yet at the end of the process must withdraw more
value from circulation than he threw into it at starting. His development into
a full-grown capitalist must take place, both within the sphere of circulation
and without it. These are the conditions of the problem".
Marx began the solution of the dilemma with a direct-and-powerful
application of the dialectic of the commodity. If the exchange-value of the
commodity cannot be the source of surplus, then the dialectical opposite of
value, use-value, remains the only possible source:
"The change of value that occurs in the case of money intended to be
converted into capital must take place in the commodity brought by the first
act, M-C, but not in its value, for equivalents are exchanged, and the commodity
is paid for at its full value. We are, therefore, forced to the conclusion that
the change originates in the use-value, as such, of the commodity, i.e. its
consumption. In order to be able to extract value from the consumption of a
commodity, our friend, Moneybags, must be so lucky as to find, within the sphere
of circulation, in the market, a commodity, whose use-value possess the peculiar
property of being a source of value".
Marx then used the quantitative difference between the exchange-value of
labour-power, with the use-value to uncover the source of surplus-value in the
transaction between worker-and-capitalist:
"The past labour that is embodied in the labour power, and the labour
that it can call into action; the daily cost of maintaining it, and its daily
expenditure in work, are two totally different things. The former determines
the exchange-value of the labour power, the latter is its use-value. The fact
that half a (working) day's labour is necessary to keep the labourer alive
during 14 hours, does not in any way prevent him from working a whole day.
Therefore, the value of labour power, and the value which that labour power
creates in the labour process, are two entirely different magnitudes; and this
difference of the two values was what the capitalist had in view, when he was
purchasing the labour power. What really influenced him was the specific usevalue which this commodity possesses of being a source not only of value, but of
more value than it has itself. This is the special service that the capitalist
expects from labour power, and in this transaction he acts in accordance with
the 'external laws' of the exchange of commodities. The seller of labour power,
like the seller of any other commodity, realizes its exchange-value, and parts
with its use-value".
Marx's Confusion?:
Keen argues that one way that Marx's negative derivation survived involved the
claim that labour-power represented the only commodity with the characteristic
of becoming "a source not only of value, but of more value than it has itself".
Marx in Das Kapital I, appeared to successfully reach the conclusion that the
means of production could not be a source of surplus-value, however, Marx did
this by contradicting a basic premise of his positive derivation, that the usevalue, with the exchange-value of a commodity are unrelated. Whereupon Marx's
positive proof contradicts the negative one by showing that 'all' inputs to
production become potential sources of surplus-value.
Whereupon Marx, in the course of his attempts to preserve the labour
theory of value premise that labour-power involves the only source for surplusvalue, he advanced 3 premises, which fundamentally contravened his general
approach to commodities:
(1). In the case of the means of production, the purchaser makes use of their
exchange-value, not their use-value.
(2). Their use-value cannot exceed their exchange-value.
(3). The use-value of commodity inputs to production somehow reappears in the
use-value of the commodities they help create.
Marx began with the simple assertion that the means of production can transfer
no more than their exchange-value to the product. Marx then attempted to create
equality between the exchange-value with the use-value of the means of
production, by equating the depreciation of a machine to the productive
capacity:
"Value exists only in articles of utility. If therefore an article
loses its utility, it also loses its value. The reason why means of production
do not lose their value, at the same time that they lose their use-value, is
this: they lose in the labour process the original form of their use-value, only
to assume in the process the form of a new use-value. Hence it follows that in
the labour process the means of production transfer their value to the product
only so far as long with their use-value they lose also their exchange-value.
They give up to the product that value alone which they themselves lose as means
of production".
As Keen asserts, the 2 final sentences which appear to link the transfer of
value by the machine to their depreciation are incorrect; the statement that the
use-value of a machine reappears in the use-value of the product equates the
use-value of the machine to the utility enjoyed by the consumers who purchase
the goods the machine produces, but the use-value of a machine remains specific
to the capitalist purchaser of the machine only, thus by arguing that the usevalue of the machine reappears in the product, Marx infact appears to become
contemplating the 'existence' of an abstract utility, with the usefulness of the
machinery transmuted into the usefulness of the commodities it produces, which
seems more the misplaced neo-classical faulty reasoning. Marx's ambiguous
statement concerns the transfer of value by the means of production. But which
of their 2 values do machines transfer, their exchange-value, otherwise their
use-value? If Marx meant that they transfer their use-value, then this sentence
would seem correct in terms of his 'analysis' of commodities; but later he makes
it clear that by this expression he means that the means of production transfer
involves not their use-value (the case with a worker) but their exchange-value.
Marx states: "its use-value has been completely consumed, and therefore its
exchange-value completely transformed to the product". Thus amounts to the
assertion that in the case of machinery, aswell as raw materials, what gets
consumed by the purchaser is not their use-value, as with any other commodities,
but their exchange-value.
This ambiguity reappears as Marx goes on to discuss the example of a
machine which lasts only 6 days. Here Marx first states the correct premise
that the machine transfers their use-value to the product, but then equates this
to their exchange-value. Marx asserted that if a machine lasts 6 days: "(t)hen,
on the average, it loses each day one sixth of its use-value, and therefore
parts with one-sixth of its value to the daily product". Though Marx at first
draws the correct inference that "means of production never transfer more value
to the product than they themselves lose during the labour-process by the
destruction of their own use-value", but the confusion he has made between
exchange-value with use-value leads him to make an incorrect conclusion:
"The maximum loss of value that they (machines) can suffer in the process, is
plainly limited by the amount of the original value with which they came into
the process, or in other words, by the labour-time necessary for their
production. However useful a given kind of raw material, or a machine, or other
means of production may be, though it may cost £150 – yet I cannot, under any
circumstances, add to the value of the product more than £150".
Marx appears to have reached this conclusion that the means of
production cannot generate surplus-value by confusing depreciation, otherwise
the loss of value by a machine, with value-creation:
(1). The maximum amount of value that a machine can lose involves its exchangevalue.
(2). Where the machine's exchange-value will fall to 0, only when its use-value
has been completely exhausted.
(3). Marx combined this to conclude that the value a machine 'adds' in
production appears equivalent to the exchange-value it loses in
depreciation.
(4). Thus with the value 'added' by a machine equated to value lost, no
net-value is transferred to the product, leaving only labor as the source
of surplus-value.
Though Marx's argument may appear plausible, it involves confusion between 2
distinct characteristics of a machine: cost (exchange-value), with their
usefulness (use-value), where for Marx, depreciation involves the writing-off of
the original exchange-value of the machine over their production life;
consequently, the maximum depreciation that a machine can suffer involves the
exchange-value, since as it wears out, both the residual value, aswell as the
usefulness will diminish, both terminating together. However, it does not
necessarily follow, that the usefulness (the value-creating capacity) of the
machine equals their cost, hence depreciation; though a capitalist will writeoff the latter completely only when the former has been extinguished, the 2
aspects are nonetheless completely different, moreover unrelated. There is no
reason why the value lost by the machine should have an equivalence to the value
'added'. As Keen asserts, "value added is unrelated to and greater than value
lost; if it were not, there could be no surplus".
Origin Of Surplus-Value III:
Interestingly while Marx first developed his dialectical 'analysis' of the
commodity while working on the rough draft of Das Kapital, so enthused with this
approach that he explored it freely with little regard it seems for how it
should follow from his previous 'analysis'. Within this mess, Keen noticed that
Marx (1857) had made a statement that correctly applied this new logic, while
directly contradicted the old, by asserting that a machine could 'add' more
value than it lost through depreciation: "It also has to be postulated (which
was not done above) that the use-value of the machine significantly (sic)
greater than its value; i.e. that its devaluation in the service of production
is not proportional to its increasing effect on production".
Whereupon Marx then supplies the following, as given in Table 7, within which,
we can see that both firms employ the 'same' (assumed such for the purposes of
this argument) amount of variable capital, 4 days' labor which gets paid 40
"thalers" (German unit of currency), the value of the labour-power purchased.
However, the first firm "Capital 1", with older capital, produces surplus-value
of just 10, while the second firm "Capital 2", with newer capital, producers a
surplus-value of 13.33. The 3.33 difference in the surplus-value they generate
becomes attributable to the difference in their machinery, moreover to the fact
that "the use-value of the machine significantly greater than its value; i.e. –
its devaluation in the service of production is not proportional to its
increasing effect on production".
Production
Paper
Press
Working
Days
Wage
Bill
Capital 1
30
30
4
40
Capital 2
100
60
4
40
Surplus
10
13.33
Output
Rate Profit
SV(%) (%)
30
25.0
10.0
100
33.3
6.7
Table 7.
Karl Marx's example where the use-value of machinery exceeds the depreciation.
From Steve Keen (2011), "Debunking Economics".
As Keen asserts, though Marx "still attributed the increased surplusvalue to labor, however, the source of this difference was not any difference in
the rate of surplus value with respect to labor employed, but to the postulate
that the machine's use-value exceeded its exchange-value".
Marx Without The Labour Theory Of Value:
Marx's dialectical 'analysis' thus contradicts a central tenet of the Labour
theory of value, that labor represents the only source of surplus-value.
Having reached this conclusion above, Marx suddenly found himself trapped, as he
had argued (in his PhD Thesis) that Hegel had to compromise with his own
principles; as Marx (1839) asserted:
"It is conceivable that a philosopher should be guilty of this or that
inconsistency because of this or that compromise; he may himself be conscious of
it. But what he is not conscious of is that in the last analysis this apparent
compromise is made possible by the deficiency of his principles or an inadequate
grasp of them. So if a philosopher really has compromised it is the job of his
followers to use the inner core of his thoughts to illuminate his own
superficial expression of it. In this way, what is a progress in conscience is
also a progress in knowledge. This does not involve putting the conscience of
the philosopher under suspicion, but rather construing the essential
characteristics of his views, giving them a definite form and reasoning, and
thus at the same time going beyond them".
The principle of the dialectical 'analysis' of the commodity appears powerful,
while the conclusion that followed 'logically' from it inescapable: the labour
theory of value could become true only if the use-value of a machine becomes
exactly equal to their exchange-value, yet the basic tenet of this 'analysis'
involved that use-value, both exchange-value are incommensurable.
If Marx had followed his newfound 'logic', the labour theory of value
would have become history. But with the labour theory of value gone, so too the
tendency for the rate of profit to fall, with the inevitability to Socialism.
The tendency for the rate of profit to fall became predicted upon the
premises:
(1). Over 'time', the capital-to-labor ratio would rise.
(2). Causing the rate of profit to fall.
(3). But dependent upon labor as the only source of surplus-value.
(4). Thus, a rising capital-to-labor ratio would mean a falling rate of profit.
If surplus could instead become generated from any input to production, not just
labor, then an increase to the capital-to-labor ratio would have any necessary
implications for the rate of profit: it could fall, otherwise stay the 'same'.
Hence with no necessity for the rate of profit to fall, there was
similarly no necessity for 'Capitalism' to give way to Socialism. Yet Marx had
prided himself upon regarding himself the scientific socialist, in contrast to
utopian socialists, who merely dreamed of a better world. Instead Marx found
that his new 'logical' tool, evidently superior to his old ones, challenges the
basis of his argument for the inevitability of Socialism.
Yet by the end of Das Kapital, Marx had convinced himself that the two
appeared consistent: that the new positive methodology concurred with the old on
the issue of the value productivity of machinery.
So Marx succeeded in compromising his theory in a way which hid the
deficiency of his principles or-both an inadequate grasp of them. But this
dubious success came with consequences, Marx's successors ignored this new
'logic', while mis-interpretated by his followers, aided by his obfuscation
which he undertook to make both methods appear consistent with one another.
'Innate' Value, An Identification:
The value a commodity has depends upon the use-value, combined with the
exchange-value, where both have become imposed upon a commodity by the process
of production. Though raw materials have a value, this again becomes determined
by the requirements of the consumer, hence not 'innate', whereupon with the
manufacturing process the capitalist undertakes due to perceived demand for a
product. Perhaps only in rare cases does a consumer determine the product
required before even the conceived idea of the need for the product, however,
any value a commodity has, derives from a transformation of the raw materials'
potential (possible functions), in the process of their exchange-value, between
capitalists, seeking to make a profit upon each stage of the production processas-a-whole. Therefore this 'concept' of 'innate' value not only appears very
quaint, but must derive from a confusion of the levels of abstraction.
Consider this, if the land 'existed' before us, therefore had no
capitalist intrinsic utility, until the first capitalist came along intent on
gaining from their use; this supposed 'innateness' of value involves therefore
an imposition of the capitalists 'wants', not a 'reality' beyond imagination,
until transformed, even after then not 'innate', because a commodity seldom has
one specific function-or-use, though originally intended so, for example, with a
brick made from the clay from the land, we can build dwellings, but more crudely
the brick can become used in other ways, as a paper-weight, to smash through a
window, to hit someone with, as a weight to ballast with, to compare (measure)
something with, etc., where each of these uses was not 'innate' within the
object, but imagined by us.
Moreover, Ricardo is wrong to consider that this 'innate' value has
nothing to do with the labor originally used to create it, such as with his
argument concerning rare commodities; whence for example in the case of a work
of art, original-and-nor-mass-produced, such as a one-off oil painting conceived
by an artist of some fame, but since died, this piece did not become valuable
because of any 'innate' value, in the canvas, nor the oil paints used, instead,
the ability-and-craft of the artist makes it valuable, though 'subjective' to a
group of people who admire it. Therefore as I have argued elsewhere, the value
is limited only by the contradictory equivalence of a finite representative
exchange-factor such as money, etc.; since the piece of art considered of such
value, that if lost, then demonstrates the assumed priceless value.
Capital: Problem Of Credit:
Sraffa (1926) in a paper, observed that an important aspect of the economic
theory of production involved the assumption that the interdependence of
industries could become ignored. The problem involves that the assumption was
invalid when changes in one industry's output affected the costs of many other
industries, which in turn determined the costs facing the first industry. As
Sraffa (1926) argues:
"...the assumption becomes illegitimate, when a variation in the
quantity produced by the industry under consideration sets up a force which acts
directly, not merely upon its own costs, but also upon the costs of other
industries; in such a case the conditions of the 'particular equilibrium' which
it was intended to isolate are upset, and it is no longer possible, without
contradiction, to neglect collateral effects".
Sraffa spent the better part of the next 35 years turning this observation into
a rigorous theoretical argument; finally outlined by Sraffa (1960), in "The
Production Of Commodities By Means Of Commodities: Prelude To A Critique Of
Economic Theory", within which Sraffa provided the techniques needed to
highlight fundamental internal inconsistencies in the Economic theory of
production.
The Economic theory of production, argues that production, 'everything'
from cornflakes to steel mills, get produced by Factors of Production, which
usually become reduced to just labor on the one side, with capital on the other.
This 'concept' ordinarily gets constructed as a Circular Flow Diagram, like that
of Figure 12. This standard economic circular flow diagram, shows factors of
production flowing from households to the factory sector, while goods flowing
from the factory sector to households. For this flow to become truly circular,
households must transform goods into factors of production, while factories must
transform factors of production into goods. The factories-to-households half of
the circle appears reasonable: factories can transform capital-and-labor inputs
into goods. To complete the circle, households must transform the goods they
receive from factories into factors of production: labor-and-capital.
Figure 14.
Standard Economic Circular Flow Diagram.
From Steve Keen (2011) "Debunking Economics".
The premise that households convert goods into labor appears
unproblematic; however, the questionable premise involves that households
further can convert goods into capital. This thus raises a crucial question:
what does capital involve in the context of this diagram? Does it involve
machinery, etc., otherwise financial instruments? If the former, then this
raises the question of where these machines get produced? Since this model
implies that households take goods produced by firms, then somehow convert them
into machines, which then get sold to firms by the households; clearly is nonsense, since in this case households must furthermore involve factories.
Therefore, this flow of capital from households to firms must involve a
financial flow. Yet Economic theory treats this financial flow as directly
contributing to production: the capital from households to firms generates a
profit back-flow from firms to households, where that profit reflects the
marginal productivity of capital. One way this could become possible: if
financial instruments directly produced output (in combination with labor),
which clearly it does not. Therefore there remains only one other possibility,
which involves acknowledging that the model is not complete. Factories actually
produce capital machines, which must be left out of the diagram. The flow of
capital from households to firms thus involves a financial flow, but hopefully
there remains a direct-and-unequivocal relationship between the measurements of
capital in financial terms with the physical productivity.
Instead, standard education in economics simply ignores these
complexities, while explains profit just as it explains wages: the payment to
capital represents the marginal productivity. The argument involves that a
profit-maximizing firm will hire capital up to the point at which their marginal
contribution to output just equals the cost of hiring it. The cost of hiring it
equals the rate of interest, while the marginal contribution equals the rate of
profit. The 2 become equal in equilibrium, so the demand curve for capital
slopes downwards, just like 'all' other demand curves, reflecting rising demand
for capital as the cost of capital falls. The 'sum' of 'all' the individual
Demand for Capital Curves gives the market demand curve for capital, while the
supply curve, the willingness of households to supply capital, rises as the rate
of interest increases. The point of intersection of this downward-sloping
demand curve with the upward-sloping supply curve yields the equilibrium rate of
profit.
However, though production supposedly occurs in the short-run, when at
least one factor of production cannot be varied, that notion only appears
arguably possible when capital remains a fixed factor, has instead been shown as
invalid. Furthermore, it makes no apparent sense to imagine that machinery now
becomes a variable while labor fixed; surely machinery should remain the least
flexible factor of production; which if that machinery can become varied, then
'everything' else can become varied too.
The arguments put forward by Sraffa against the 'concept' of diminishing
marginal productivity can moreover become applied here in a simple, but
devastating critique, first put formally by A. Bhaduri (1969): as with the
labor-market, the capital-market, broadly defines an industry, whereupon there
involves thousands of products, lumped together into the general rubric of
capital, where moreover there is no industry which does not use some capital as
an input; whereupon this then raises Sraffa's argument, that the change in the
price of such an input would affect numerous industries, therefore alter the
distribution of incomes.
If we notionally divide 'all' people into workers-or-capitalists, then
total income will involve the 'sum' of wages-and-profits. Profits in turn
involve the product of the rate of profit x the amount of capital hired.
Applying this at the level of the single firm, this gives the relationship that:
I = Wr x E + Pr x Cs
Equation 11.
where I, Income.
Wr, Wage-rate.
E, Number of employees.
Pr, Rate of profit.
Cs, Capital stock.
If we now consider changes in output which we have to do to derive the marginal
product of capital, then following a rule of mathematics, the changes in output
have to equal the changes in wages-and-profits; while another rule of
mathematics allows us to decompose the change in profits into 2 parts: the rate
of profit x the change in capital, while the capital x the change in the rate of
profit, which yields:
Ic = Wc + Pc
Equation 12.
where Ic, Change in income.
Wc, Change in Wage bill (aggregate).
Pc, Change in profit (disaggregate).
Disaggregating changes in profit leads to the formulation:
Ic = Wc + Pr x Ca + C x Pc
Equation 13.
where Ic, Change in income.
Wc, Change in Wage bill.
Pr, Rate of profit.
Pc, Change in rate of profit.
C, Capital.
Ca, Amount of capital.
At the level of the individual firm, economists assume that Wc, both C x Pc, = 0:
a change in the firm's level of output becomes causal solely by hiring more
capital has no impact on the real-wage nor the rate of profit. Thus the
relationship entails:
Ic = Wc + Pr x CC + C x Pc
Equation 14.
where Ic, Change in income.
Wc, Change in Wage bill.
Pr, Rate of profit.
Pc, Change in rate of profit (0).
C, Capital.
Cc, Change in capital (where the ratio of a change in capital to a change
in capital = 1).
Cancelling out the terms we know as 0-or-1, yields the desired relationship:
Mp = Pr
Equation 15.
where Mp, Marginal Product of Capital (Change in output due to a change in
capital).
Pr, Rate of profit.
However, while this appears a reasonable approximation at the level of the
individual firm, it does not hold true for the level of the economy-as-a-whole.
Where any change in capital will definitely have implications for the wage-rate,
moreover, the rate of profit. Therefore the resulting aggregate relationship:
Mp = (Wc, Cc) + Pr + Ca x  (Pc, Cc)
Equation 16.
where Mp, Marginal Product.
Ca, Amount of capital.
Cc, Change in capital (non-zero).
Pr, Rate of profit.
Pc, Change in rate of profit.
, Function of ().
The rate of profit will therefore not equal the marginal product of capital
unless (Wc, Cc), both Ca x (Pc, Cc), exactly cancel each other out: applies only
when the capital-to-labor ratio remains the 'same' in 'all' industries, thus
effectively only one industry. Therefore at the aggregate level, the desired
relationship, Mp = Pr, will not hold true.
Thus proves Sraffa's assertion that, when a broadly defined industry gets
considered, changes in their conditions of supply-and-demand will affect the
distribution of income. A change in the capital input will change output, but
it further changes the wage, moreover the rate of profit. These changes alter
the distribution of income between workers-and-capitalists, therefore will alter
the pattern of demand. A similar argument thus applies to wages, so that in
general a person's income will not be equal to their marginal contribution to
output. Consequently, the distribution of income is neither meritocratic nor
determined by the market. Instead, the distribution of income involves to some
significant degree, the independent determination of marginal productivity,
along with the supply-and-demand.
Therefore, this involves what mathematicians term a further Degree of
Freedom to the model of the economy. To work out the prices, it first becomes
necessary to know the distribution of income, where there will involve a
different pattern of prices for each different division of the economic cake
between workers-and-capitalists. Therefore, there is nothing sacrosanct about
the prices that apply in the economy, furthermore similarly nothing sacrosanct
about the distribution of income. Instead, it reflects the relative power of
different groups in society, though somewhat constrained by limits set by the
productive system.
This contradicts Economic theory, which asserts that the distribution of
income uniquely becomes determined by the market, therefore there is nothing
that policy-makers can-or-should do to alter it; ofcourse this argument has
previously been eliminated by the benevolent central authority assumption
derived from the Sonnenschein-Mantel-Debreu (SMD) conditions. Therefore, rather
than prices determining the distribution of income as economists allege, the
distribution of income determines prices; where within limits, the distribution
of income gets determined not by market mechanisms, but by relative political
power.
Though Bhaduri's critique still accepts the assumption that it remains
possible to define a factor of production called capital, however, I agree with
Keen, that the machinery aspect of the term capital covers too great a multitude
of things to become easily reduced to one homogeneous mass; since it tries to
includes machines, buildings that house them, trucks, ships, places, oil wells,
steel works, power stations, etc., where each of these items consists of
numerous other sub-assemblies which themselves involve commodities.
The only thing that such disparate commodities obviously have in common
involves price, which economists prefer to aggregate as capital, however, the
price of a piece of capital should depend on the rate of profit, while the rate
of profit will vary as prices change: there is an impossible circularity in this
method of aggregation.
Sraffa (1960), had specifically considered this problem, whereupon his
meticulous method uncovered a number of paradoxes that invalidated the
simplistic beliefs economists held about the relationship between productivityand-income. Just as the peculiar conditions of production of labor complicate
the argument that the wage equals the marginal product of labor, so do the more
conventional conditions of the production of capital disturbs the argument that
profit represents the marginal productivity of capital.
One of the many issues with which Keynes failed to convince his fellow
economists involved the importance of money in modeling the economy; one reason
for this involved money's explicit role in the General Theory itself, remained
largely restricted to the impact of expectations about an uncertain future,
along with the difference between real-and-nominal wages. However, Keynes
(1936) acknowledged, that money did not feature heavily in his technical
'analysis', though that he saw a overwhelming continuity between monetary
'analysis', with that of Marshallian model of supply-and-demand:
"...whilst it is found that money enters into the economic scheme in
an essential and peculiar manner, technical monetary details falls into the
background. A monetary economy, we shall find, is essentially one in which
changing views about the future are capable of influencing the quantity of
employment and not merely its direction. But our method of analyzing the
economic behavior of the present under the influence of changing ideas about the
future is one which depends on the interaction of supply and demand, and is in
this way linked up with our fundamental theory of value. We are thus led to a
more general theory, which includes the classical theory with which we are
familiar, as a special case".
It is therefore difficult to attack Neo-classical supply-and-demand-orientated
models of money as mis-representations of Keynes. Nonetheless, the postKeynesian school has made the fundamental importance of money a by-word of their
'analysis'. An fundamental aspect of this involves the empirically based
'analysis' of how money gets created, which contradicts the conventional
fractional reserve banking, Money Multiplier model of money formation.
Having empirically eliminated one model of money creation, initial
attempts to create another, appeared clumsy; rather than the vertical money
supply curve of Hicks' IS-LM model, some post-Keynesian economists proposed a
horizontal money supply curve, in which banks simply passively supplied whatever
quantity of credit money firms wanted, at the prevailing interest rate. This
model, known as "Horizontalism", led to a lengthy dispute within post-Keynesian
economics over whether the money supply curve involved a shape that appeared
horizontal-or-upwards. This dispute put the empirically accurate findings of
post-Keynesain researchers into the very methodological strait-jacket that Neoclassical economics itself employed: equilibrium 'analysis' of intersecting
supply-and-demand curves. Though this was hardly the intentions of the
originators of endogenous money 'analysis', it effectively made monetary
'analysis' an extension of supply-and-demand 'analysis'.
For real 'analytic' progress, required a watertight basis for Keynes'
assertion that money enters into the economic scheme in an essential-andpeculiar manner, aswell as a methodological approach that captured the feed-back
effects that diagram-and-equilibrium 'analysis' could not.
The Money Circuit school in Europe supplied the former, where
specifically Augusto Graziani (1989) argued that, if money gets treated as just
another commodity subject to the laws of supply-and-demand, then the economy
effectively represents a Barter Economy (system): where just one more commodity
gets 'added' to the mix, else singled out as the commodity through which 'all'
barter must occur; this represents a quantitative not a qualitative change, yet
something qualitative must change if a Monetary Economy can be distinguished
from a barter system.
Graziani's insight involved that for a monetary economy to become clearly
distinguished from a barter economy, the monetary economy could not use a
commodity as money. Therefore money had to be a non-commodity, something that
remains intrinsically worthless, while could not be simply produced as
commodities themselves can: "a commodity money is by definition a kind of money
that any producer can produce for himself. But an economy using as money a
commodity coming out of a regular process of production, cannot be distinguished
from a barter economy". This then led to a simple but profound principle: "A
true monetary economy must therefore be using a token money, which is nowadays a
paper currency". Now, the fact that:
(1). a monetary economy uses a token, something that remains intrinsically
worthless, as a means of exchange implies 2 further important conditions,
that "In order for money to exist:
(2). money has to be accepted as a means of final settlement of the transaction
(otherwise it would be credit and not money);
(3). Money must not grant privileges of seigniorage to any given agent making a
payment".
From this Graziani derived the insight that "any monetary payment must therefore
be a triangular transaction, involving at least three agents, the payer, the
payee, and the bank":
"The only way to satisfy those three conditions is to have payments
made by means of promise of a third agent, the typical third agent being
nowadays a bank...Once the payment is made, no debt and credit relationships are
left between the two agents. But one of them is now a creditor of the bank,
while the second is a debtor of the same bank".
Thus this perspective clearly delineates a monetary vision of 'Capitalism' from
the Neo-classical barter paradigm.
Therefore, banks remain a fundamental component of 'Capitalism',
inherently different to industrial firms: where firms produce goods (with
services) for sale by combining labor-and-other-commodities in a production
process that takes both time-and-effort; while banks generate-and-honor promises
to pay, used by third parties to facilitate the sale of goods; where they incur
essentially no costs in doing so, whereas the cost of producing a dollar is much
less than a dollar, thus the source of Graziani's third structure that the
system cannot enable banks to exploit this opportunity for seigniorage.
Therefore, firms-and-banks must clearly become distinguished in any model of
'Capitalism': "Since in a monetary economy money payments necessarily go through
a third agent, the third agent being one that specializes in the activity of
producing means of payments (in modern times a bank), banks and firms must be
considered as two distinct kinds of agents...In any model of a monetary economy,
banks and firms cannot be aggregated into one single sector".
Commodity X
Agent A
Agent B
Commodity Y
Figure 15.
The Neo-classical model of exchange as barter.
In the Neo-classical world, transactions involve two-sides, two-commodity,
barter exchanges: person A gives person B one unit of commodity X in return for
some number of units of commodity Y. Whereupon calling one of these the money
commodity does not alter the fundamental barter nature of the transaction.
Agent A
Commodity X
Agent B
Bank Z
A
B
Account
Account
+$300
-$300
Figure 16.
The nature of transactional exchanges in the 'real' world.
In the Monetary world, transactions involve three-sides, single-commodity,
financial exchanges: person B instructs bank Z to debit Y units of currency from
B's account, then credit A's account with the 'same' amount, in return for which
person A gives person B one unit of commodity X.
This simple but profound perspective on what constitutes a Monetary
Capitalist Economy yielded 2 fundamental requirements for a model of
'Capitalism':
(1). 'all' transactions involve transfer of funds between bank accounts;
(2). the minimum number of 'classes' (economists usually use the term agents
here, but 'social class' remain an 'objective' 'reality' in 'Capitalism')
in a model of 'Capitalism' involves 3: capitalists, workers, bankers.
Moreover this implies that the best structure for modeling the financial side of
'Capitalism' involves a double-entry system of bank accounts. Consequently from
this, Keen then developed a means to derive Dynamic Monetary models of
'Capitalism' from a system of double-entry book-keeping accounts (Keen 2008,
2009, 2010, 2011); but is not the concern of our discussion here.
"Assumptions Don't Matter"?:
Assumptions, like any theory, explanation, axiom, premise, etc., do matter
because they lead to consequences; otherwise as scientists term to predictions.
The problem of proving-and-validating has become something of a vexed
question. Empiricalism's Simple Enumeration, which entailed observing the
occasions that provide, confirming results for the premise, has the flaw that if
once an instance contradicts the supposed premise then the theory fails; such as
the Scottish empiricist David Hume (1711-76) had argued, that with this simple
enumeration only an infinite number of such confirming results could prove the
theory correct. However, on-the-whole scientists along with philosophers of
science believe that what distinguishes the Social Sciences from the Natural
(empirical) Sciences, involved that the latter could undertake experiment to
test their theories, whereas the former usually could not. Where according to
the traditional scientific view, a 'hypothesis' (Greek hupothesis: 'deduced'
particular, consequence, conclusion, etc) may become tested-and-verified by
obtaining the 'repeated' outcome of supporting observations (via experiments),
whereupon exceptions would disprove a theory; something presumably elaborated
upon simple enumeration. However, the flaw here involves that one can nearly
'always' design an experiment to prove what the scientist wishes to; otherwise
that scientists have often cited only those experiments which provide the proof
for their pet theory; though more often than not the derived explanation of the
results becomes the problem, since it may later become shown as false by a more
intricately designed experiment. Ofcourse, the 'best' theory does not mean that
the previous theory was wrong, nor that the successive theory is entirely right
(theories, etc., even the supposed facts, represent abstractions of 'reality',
not ever 'concrete' because these events-in-themselves become transformed
(represent approximations) via our evolving nervous systems), simply that the
successive theory can predict phenomenon that other theories could not, for
example, Isaac Newton's theory of gravity (1687), super-seceded by Albert
Einstein's (1916) General theory of Relativity; though regardless, this has
often resulted in scientists grouping themselves into camps in favor of one
theory over the others.
Aristotle had (350 B.C.) originally devised both inductive-and'deductive' 'logic' systems, with which Francis Bacon (1920), revised the
inductive methodology into Science with "Novum Organum" ("New Organum", New
Instrument, methodology, etc), while later Karl Raimund Popper (1934), in his
"Logik Der Forschung" ("The Logic Of Scientific Discovery"), gave to the
Philosophy of Science, his major contribution involving his rejection of the
inductive method in the empirical Sciences with instead his 'deductive'
Falsifiability Criterion: whereupon 'hypotheses are deductively' validated, by a
scientist who seeks to discover an observed exception to this premise, whereupon
the absence of contradictory evidence thereby becomes corroboration of his
theory; though this entails more often than not, invalidating the 'hypothesis'.
Popper argued that the distinction a Science, like that of Physics, with
a Non-science, like that of Astrology, was not that one would perform
experiments while the other did not, but that one made falsifiable statements
which could become provable as true-or-false, while the other did not bother to
disprove them; this distinction played down the importance of experimentation in
deciding a Science from a Non-science. Nonetheless, however put, the history of
economics implies that Popper's distinction does not give sufficient attention
to whether-or-not a falsifiable premise can it fact become experimentally
falsified.
Whereas Popper meant a 'deductive' falsification of assumptions via
observed exceptions, where only the lack of any contradictory evidence proves
the assumption, Keen instead suggests that neo-classical economists based their
methodology upon Philosophy advanced by John Dewey's (1859-1952) 1938,
Instrumentalism: asserting that what remains most important in a thing-or-idea
involves value as an instrument of 'action', whereupon that the truth of an idea
lies in their usefulness. Since that the premise of Instrumentalism involves
that a theory is not regarded as a description of 'reality', but merely as a way
of predicting the future; here I agree with Keen that neo-classical economists
have adopted this, particularly since economists seemingly base themselves on
the one-side of the formula, ignoring the assumption, while focusing on the
prediction. Moreover, Instrumentalism seems a natural follow on from Bentham's
Utility Theory, implying a healthy dose of agnosticism, while appearing
scientific since many scientists would agree that their theories remain only
abstractions of 'reality', so not 'concrete'; however its persuasion is
superficial, has flaws as argued by the philosopher Alan Musgrave. Moreover,
assumptions should matter to economists, since they genuinely believe that their
theories describe 'reality', while reject any economic argument that is not
based upon their own preferred set of assumptions.
Musgrave (1981), regards Instrumentalism as an invalid methodological
defense, arguing that neo-classical economists confuses 3 kinds of assumptions:
(1). Negligibility assumptions: state that some aspect of 'reality' has
little-or-no-effect on the phenomenon under investigation.
(2). Domain assumptions: which determine the range of applicability of a given
theory.
(3). Heuristic assumptions: those established via trial-and-error.
However Friedman (1953), appears to have provided economists with a way out:
"the more significant the theory, the more unrealistic the assumptions". Though
Keen asserts that Friedman's paradoxical statement remains only partially true
of the first kind (negligibility assumptions), but manifestly untrue of the
latter 2 (domain, heuristic, assumptions), I disagree that we can even ignore
the first, since, following Edward Lorenz's (1979), Butterfly Effect, initial
conditions results in massive unpredictable changes, entails that any given
assumption made no matter how insignificant will have lead to special
consequences for a theory.
Infact, Friedman went even further: "that unrealistic assumptions were
the hallmark of a good theory"; which Samuelson later termed the F-twist, as
Friedman (1953), asserted:
"Truly important and significant hypothesis will be found to have
'assumptions' that are wildly inaccurate descriptive representations of reality,
and, in general, the more significant the theory, the more unrealistic the
assumptions (in this sense). The reason is simple. A hypothesis is important
if it 'explains' much by little, that is, if it abstracts the common and crucial
elements from the mass of complex and detailed circumstances surrounding the
phenomena to be explained and permits valid predictions on the basis of them
alone. To be important, therefore, a hypothesis must be descriptively false in
the assumptions; it takes account of, and accounts for, none of the many other
attendant circumstances, since their very success shows them to be irrelevant
for the phenomena to be explained.
To put this point less paradoxically, the relevant question to ask about
the 'assumptions' of a theory is not whether they are descriptively 'realistic',
for they never are, but whether they are sufficiently good approximations for
the purpose in hand. And this question can be answered only by seeing whether
the theory works, which means whether it yields sufficiently accurate
predictions".
Nevertheless this has lead economists to argue, much in the tradition of
scientists in the empirical Sciences, grouping together into camps arguing
against each other's 'reality'. Let us take for example, Friedman's Monetarism
premise, that "inflation is caused by the government increasing the money supply
faster than the rate of growth of the economy", which has become falsified by
events (previously discussed), but this did not lead Friedman to abandon this
theory, Monetarism instead argued that 'all' sorts of attenuating features
disturbed the results; though 'everyone' else had moved on. In other words,
since the monetarist experiment in the United Kingdom (UK), was not a
'controlled' experiment, monetarist economists could refuse to accept that their
theory had been falsified.
Many of the foundations on which Neo-classical Macro-economics rests
upon, arose from persevering with methodological choices that the 19th-century
founding fathers of Neo-classicism made out of expediency rather than
preference. The neo-classical economists assumed that 'all' economic processes
occurred in equilibrium, so that they could model the economy using comparative
'statics' rather than using more difficult dynamic differential equations: they
avoided 'thinking' about money, modeling the simpler process of barter instead;
they ignored uncertainty about the future, while as Keynes (1937) stated it,
tried to "deal with the present by abstracting from the fact that we know very
little about the future", etc. Though these choices made it easy to concoct
simple parables about supply-and-demand, they actually made mathematical
modeling of the economy harder. The absurdities that later neo-classicalists
included, from the fallacy of the horizontal demand curve to the intellectual
travesty of the representative agent, represented products which clung to these
simple parables, despite the deep research that contradicted them.
Infact assumptions, like premises, etc., have a "Logical Destiny"
("Logical Fate"), after Casssius Jackson Keyser (1922), with Alfred Korzybski
(1923), which relates the connection between our intellectual freedom with that
of the 'logical' consequences which must follow from the choices made. Moreover
as I have argued elsewhere, the answer for scientific investigation lies with
empirical 'logico'-mathematic probability; though not as 'certain' levels of
risk, as previously argued. However, explaining-establishing both methodologies
is not the concern for us here.
Mathematics as a tool, for physicists in particular, has enabled them to
accurately envisage the cosmos without the limitations of a majoritively twovalued language structure; whereupon physico-mathematical theories have made
numerous predictions, as yet un-verifiable via experiments, due to the current
near-impossible technological advances required to design the experiments
needed; yet where such physical theories have become possible as to validate via
empirical necessities, they for the most part appear to have become
substantiated. Instead however, neo-classical economists have managed to
obscure 'reality' using mathematics, because they themselves have not realized
the limits of mathematics; it appears to involve the old myth of "proving what
one wishes to be so, as to what really is so".
Nevertheless, Neo-classical economics' dismissal of the importance of
initial assumptions makes it unscientific.
The Shock Doctrine:
Naomi Klein's (2007), "The Shock Doctrine: The Rise Of Disaster Capitalism",
explodes the myth that the global free-market triumphed democratically. Klein
introduces what she calls the Shock Doctrine: the use of public disorientation
following massive collective shocks, wars, terrorist attacks, natural disasters,
etc., to push through unpopular economic measures often called Shock Therapy;
combined with Disaster Capitalism: the rapid-fire corporate re-engineering of
societies that are reeling from shock.
Figure 17.
Naomi Klein (1970-).
These policies, Klein argues did not begin with September 11, 2001
(9/11), but she has traced their intellectual origins back 50 years to the
Chicago School of Economics department under Friedman. Central to Klein's
thesis involves the contention that those who wish to implement unpopular freemarket policies, now routinely do so by taking advantage of specific features of
the aftermath of major disasters, whether economic, political, military,
natural, etc. That after a society experiences such a major 'shock', that while
there occurs an international desire for a rapid-and-decisive 'response' to
correct the situation, however, this desire for bold-and-immediate 'action'
provides an opportunity for unscrupulous agents to implement policies which go
far beyond a legitimate 'response' to the disaster. Klein argues that in the
ensuing chaos from the shock, that much can go unscrutinized-or-recognized, such
that in this moment that unpopular-and-unrelated policies can become
intentionally rushed into effect; Klein goes further to even suggest that
shocks, in some cases, become intentionally encouraged, otherwise even
manufactured.
Klein provides many examples, of the employment of Disaster Capitalism,
such as at the most chaotic juncture in Iraq's civil war, a new law got passed
that would allow Shell, aswell as BP, to claim the county's vast oil reserves;
policy initiatives, such as the privatization of Iraq's economy under the
Coalition Provisional Authority; immediately following 9/11, the Bush (US.,
President George Bush, Jr) administration quietly out-sourced the running of the
war on terror to Halliburton and Blackwater; after the a tsunami devastated the
coasts of South-East Asia, the pristine beaches got auctioned off to tourist
resorts; New Orleans's residents, while still scattered from Hurricane Katrina,
discovered that their public housing, hospitals, schools, etc., will never again
open; etc. Moreover, Klein shows how the deliberate use of the Shock Doctrine
has made the free-market policies of the Chicago School of Economics prominent
in producing world-changing events such as Pinochet's (Augusto Pinochet Ugarte;
leader of the military junta that overthrew the socialist government of
President Salvador Allende of Chile on September 11, 1973; Pinochet subsequently
headed Chile's military government, 1974–90) coup in Chile in 1973, the
Tiananmen Square Massacre in 1989, the collapse of the Soviet Union in 1991,
etc.
Gestalt:
The Neo-classical theory that price falls when demand rises, enables them to
argue for a 'perfect' 'competitive' 'capitalist' system, within which different
firms can compete 'equally' for a slice of the market, without having to
monopolize the price of their commodities. Instead, as discussed what can
'really' happen, involves price rising as demand rises, just as likely as price
rising while there is no change in demand levels, demand rising with price,
etc., but what determines these separate events, is not something that can with
'certainty' become planned for, since the whims of the multitude are not
predictable, because these agents are not 'rational'. An example, the 1960s
craze for hula-hoops, which the manufacturer had stocked-piled for Christmas
period sales, because of the massive initial demand in sales, which then
consequently never happened.
The relation between inflation-and-employment remains a problem: the
price of food, housing, rent, if-and-when they rise, creates tension on a
workers wage, in turn puts tension upon the producers costs, completing a circle
back onto commodities such as food, housing, rent, which forces inflation to
rise. There should be no reason why the rate of employment should become
drastically affected outside of recessions, however, as discussed, the
producer's affordability for more workers depends on demand for the producer's
goods, in turn relies upon the wage packet of the worker, whereupon this
relation cycles up-and-down. From this it seems plausible that the difference
between the worker's wage packet to that of the prices of the commodity, not
only continues to imbalance the system, but count towards the initiation of
recessions. To give a crude example, if a firm continues to pay their workersand-CEOs, a rate, but contrary to a decline in the rate of profits, then this
may result in tension consequent with the firm's bankruptcy, if however, we then
factored in the reliance of other firms-and-small-businesses who may supply raw
materials, other services, such as banks with loans, this may have a
deteriorative effect on the economy creating a mini-recession, especially if
causing a run on the financial stock-market aswell. This a direct result of a
consideration of a dynamic-market, where any balances remain very precarious.
The value that a commodity has cannot be 'always' evident within, thus
'innate', since for such an imposition relies upon subjectivities both made by
the consumer-and-producer, furthermore involving changing circumstances. A rock
has no 'normal' value as a 'commodity', thus considered not useful for some
purpose, however, in the right situation a Chimpanzee may provide this rock with
a usefulness, who wishes to use it as a hammer, for example, to crack nuts with;
hence this utility is not self-evident, but instead dependent upon the needsand-imagination of the consumer. From this Marx appears partly correct in that
labor provides a source of surplus-value, further in that machinery having
become constructed specifically via labor's design, can moreover increase
surplus-value, since it can impart a commodity with value via their
construction. This seems lost until one looks for the similarities between
human labor compared to what must essentially become viewed as synthetic labor,
constructed by humans, or-both improving upon humans' ability to provide labor.
Since, like that of human labor, machines can become obsolete in their
technological abilities (where laborers can become trained-and-retrained),
however, machines in themselves cannot be re-trained without perhaps the
software required by the computers that may come to 'control' them,
nevertheless, like humans, machines can wear-out, here humans become too old,
inflexible to adapt.
However, what both classical-and-neoclassical theorists fail to consider
seriously, involves the increasing rarity, otherwise, quality-and-specialist
considerations of a commodity, like that of a pencil, whether constructed by
human labor-or-machines, on a time-intensive individual basis otherwise
mechanized mass-produced, when like unique works of Art, that come to 'exist' in
a world devoid of other pencils, can both have value-and-valueless significance
depending upon who-or-not chooses to utilize it.
Nonetheless, that 'Capitalism' reflects a system for the self-interests
of individuals interested in the self-acquiring of capital (whether this takes
the form of land-or-savings-or-consumables-or-whatever-possible) over-and-above
'all' others, is not in dispute; any such Economic system that regards the
ethics of the few as more equal than the rest, ironically cannot be thus moral.
The corporate-and-financial elite may have played a role in enabling neoclassical economists to continue believing false-to-facts non-sense as they
developed their theories, since it seems that Neo-classical theory serves the
interests of the elite; despite being counter-productive for the economy itself.
'Concepts' which Economic theory has ignored, such crucial issues like the
distribution of wealth, the role of power in society, etc., surely involves what
this elite want to hear; thus false-to-fact rubbish becomes the dogma of the
conceited selfish, who in turn spread the arrogant propaganda of self-centered
non-sense.
Classical-or-Neo-classical Economic theory's insistence in achieving
equilibrium, 'constants', 'control' of inflation, employment, etc., becomes
useless in the light of capitalists creating capital. Equilibrium for example,
from the Latin for oequilībrium (Equi-, lībrare, to balance, from lībra, a
balance) means a 'state' of equal balance, due proportion in parts, a 'state' of
rest-or-balance due to 'action' of forces which counter-act each other, equal
balance of the 'mind' between conflicting forces-or-reasons, etc., which rarely
if ever, is an 'equal' balance of forces, nor at rest; while the case for
'constants' has often more-than-not, involved exceptions to this, for example,
the supposed 'constant' of gravity is not so in many instances such as in a
free-falling lift; whereupon both imply the further illusion of no change in
'time'. Instead, 'Capitalism' via their capitalist masters, demand the raising
of capital via increasing profits, thus increase in productive growth,
regardless of their consequences upon the Earth's resources, nature, the
majoritative poor, employment rates, any fairness, nor for that matter humanityas-a-whole. Therefore, instead of an economic democracy of the free-market,
otherwise a meritocracy, 'Capitalism' results in an oligarchy, with an
increasing wealth-thus-power residing in the hands of a disparate few. Similar
to the neutrality of nature, 'Capitalism' has no ethics system (since the
creation of humanity), other than what we expect of it. Therefore, 'Capitalism'
enslaves humanity to maximizing profits.
Therefore Klein's assertions concerning Disaster Capitalism, would not
surprise me in the least, I hope not because of a cynicism of humanity-as-awhole, but that the policies of 'Capitalism' are not altruistic at heart; it
moreover seems to make sense that those in power, who seek more power-and-wealth
would welcome Neo-classical Economic doctrines, since they argue for a freemarket free of regulation, such that this provides them with a freedom from
restraints to do whatever they like in order to make a profit.
In the UK., housing prices have consistently risen preceding each bust
since the 1970s; though with the last Financial Crisis, this relationship with
initiating the recession appears co-incidental. A number of factors appear
causal upon this, firstly the housing-market naturally rises in price as
inflation drives down the value for money, however, the UK., Conservative
government's policy of the 1980s, of letting tenants buy their Council houses,
the rising population related to the ratio of new homes built by the housing
industry, finally perhaps, the rise of the housing property business person, who
invests in buying properties, redecorating them, then selling them on at a
greater selling price in order to make a profit; ofcourse, not 'all' of these
property business entrepreneurs intend to sell-on, but instead as landlords
intended to increase their private rented accommodation property stock,
especially if the selling-price, for example, during a recession could not
provide a sufficient profit from actual cost in investment-and-remodeling.
Nevertheless the result-as-a-whole, increases the growth (month-by-month) of the
housing sector, driving GDP in an ever-upward curve, which itself signals the
inevitable inversion from boom-to-bust. Since inevitably, people will-not-orcannot pay the price demanded due to some differentiated tension between the
steep curve of housing prices to that of wage, while related to mortgage
affordability. These re-occurring episodes in the housing price rise, in each
decade preceding a recession had made me concerned about the inevitability of
the recent Financial Crisis, though ofcourse, what instead had happened involved
not the housing-market directly, but the sub-prime loans, a process which
initially involved the renting out to tenants in the US., properties which they
could ill afford ordinarily. However, this makes an example for my argument
that 'Capitalism' cannot be modeled by equilibriums, since instead small
businesses, firms, etc., intend to make more-and-more profit, year-in-year-out,
thus driving the economy in an ever-upward curve. As James E. Lovelock (2009),
has observed that instead of trying to predict the point of down-turn ("tippingpoint"), a more reliable indicator involves the steepness of the up-turned curve
representing the increasing economic prosperity. Therefore, it appears to me
supportive that 'Capitalism' drives economic booms-and-busts.
The requirement for Economic theory involves the setting-aside
Aristotelian (after Aristotle, 350 B.C.), two-valued ('certainty'),
'elementalistic' ('analysis'), 'static' (thus homogeneous: 'all the same', etc),
processes-and-explanations, unsuited to 'reality' of an economy in function.
The above argument though in the most part developed by Keen (2011), in
his "Debunking Economics", I have organized this Supplement in such a way, which
hopefully shall allow a clearer if not less complex presentation; ofcourse I do
not entirely agree with economic 'analysis', whether Neo-classical, Marx,
Keynes, nor Keen, such that I have made some important departures from Keen's
discussion. However, for a more detailed discussion-and-presentation of the
problems of Economic Theory, I recommend that you research Keen, whose
"Debunking Economics", you will find in the list of References below. Since
some matters I have covered elsewhere in greater detail, such that with regard
to these have instead referred to them, again listed in the References. This
Supplement for example made involves as an extension the discussion previously
established in my essay (2010) "Trans-Economics", including my (2012)
"Supplement IX: Keynes Vs Hayek: Dynamics Of Booms-And-Busts".
APPENDIX
The Taylor Rule.
In Economics, the Taylor Rule, first proposed by John B. Taylor in 1993 (whilst
independently by Dale W. Henderson, with Warwick McKibbin), represents a
monetary-policy rule that stipulates how much the Central Bank should change the
Nominal Interest Rate in 'response' to changes in inflation, output, other
economic conditions, etc. In particular, the Taylor Rule stipulates that for
each 1% increase in inflation, the Central Bank should raise the nominal
interest rate by more than 1% point; this aspect of the rule often becomes
termed the Taylor Principle.
The Taylor Rule intended to foster price stability, along with full
employment, by systematically reducing uncertainty-and-increasing the
credibility of future actions by the Central Bank; moreover may avoid the
inefficiencies of 'time' inconsistency from the exercise of discretionary
policy. The Taylor Rule synthesized, providing a compromise between, competing
schools of economics 'thought' in a language devoid of rhetorical passion;
though many issues remain unresolved, while views still differ about how the
Taylor Rule can best become applied in practice, Neo-classical research seems to
show that the rule has advanced the practice of Central Banking.
Keen (2011), "Debunking Economics", Pg: 267:
"The Taylor Rule was first devised by John Taylor as a reasonable
empirical approximation to the way the Federal Reserve had in fact set nominal
interest rates (Taylor 1993: 202). He noted that the Fed had increased the cash
rate by 1.5 percent for every percent that inflation exceeded the Fed's target
inflation rate, and deduced the cash rate by 0.5 percent for every percent that
real GDP was below the average for the previous decade. When New Keynesian
economists incorporated this in their model, they introduced the neoclassical
concept of an 'equilibrium' real rate of interest (which is unobservable), so
that if actual inflation and the rate of growth were equal to their target
levels, the cash rate should be equal to the inflation rate plus this
unobservable 'equilibrium' rate.
After the crisis hit, Taylor himself blamed it on the Fed deviating from
the rule:
Why did the Great Moderation end? In my view, the answer is simple. The Great
Moderation ended because of the 'Great Deviation', in which economic policy
deviated from what was working well during the Great Moderation. Compared with
the Great Moderation, policy became more interventionist, less rules-based, and
less predictable. When policy deviated from what was working well, economic
performance deteriorated. And lo and behold, we had the Great Recession.
(Taylor 2007: 166)
There is some merit in Taylor's argument – certainly the low rates in
that period encouraged the growth of Ponzi behavior in the finance sector. But
his neoclassical analysis ignores the dynamics of private debt, which, as I shoe
in Chapters 12 and 13, explain both the 'Great Moderation' and the 'Great
Recession.' Taylor's Rule was more of a statistical coincidence in this period
than a reason for the stability prior to the recession.
The Rule also evidently gave Taylor no inkling that a crisis was
imminent, since as late as 10 September 2007, he concluded a speech on his Rule
with the following statement:
Of course, we live in a fluid economic world, and we do not know how long these
explanations or predictions will last. I have no doubt that in the future – and
maybe the not so distant future – a bright economist – maybe one right in this
room – will show that some of the explanations discussed here are misleading, or
simply wrong. But in the meantime, this is really a lot of fun. (Ibid.: 15;
emphasis added)".
Formulating The Taylor Rule:
According to Taylor's original version of the rule, the nominal interest rate
should 'respond' to divergences of actual inflation rates from target inflation
rates, while actual Gross Domestic Product (GDP) from potential GDP:
‗
it = πt + rt* + aπ (πt-πt*)+ ay (yt – yt)
Equation 17.
Where it, Target short-term nominal interest rate (e.g., the federal funds rate
in the US., while the UK., Bank of England base rate).
πt, Rate of Inflation as measured by GDP deflator.
πt*, Desired rate of inflation.
rt*, Assumed equilibrium real interest rate.
yt , Logarithm of real GDP.
‗
yt , Logarithm of potential output, as determined by a 'linear' trend.
In this formula, both aπ with ay should remain positive (as a rough rule of
thumb, Taylor's 1993 paper proposed setting aπ = ay= 0.5). Taylor's Rule
recommends a relatively high interest rate (a tight monetary policy) when
inflation gets above the target, otherwise when output gets above the fullemployment level, in order to reduce inflationary pressure; whereas Taylor's
Rule recommends a relatively low interest rate (easy monetary policy) in the
opposite situation, to create output. On occasion monetary policy goals may
conflict, as in the case of stagflation: when inflation gets above the target,
while output falls below full-employment; in such a situation, the Taylor Rule
specifies the relative weights given to reducing inflation versus increasing
output.
The Taylor Principle:
By specifying aπ > 0, the Taylor Rule states that an increase in inflation by 1%
point should prompt the Central Bank to raise the nominal interest rate by more
than 1% point: specifically, by 1 + aπ the 'sum' of the 2 co-efficients on πt in
the formula above. Since the real interest rate appears approximately the
nominal interest rate - inflation, stipulating aπ > 0, implies that when
inflation rises, the Real Interest Rate should GET increased. This idea then,
that the real interest rate should get raised to cool the economy when inflation
increases (requiring the nominal interest rate to increase more than inflation
does) has occasionally become termed the Taylor principle.
Taylor has stated the rule in simple terms using 3 variables: inflation
rate, GDP growth, along with the interest rate. If inflation rose by 1%, the
proper 'response' would be to raise the interest rate by 1.5%; Taylor explains
that it does not 'always' need to be exactly 1.5%, but must essentially become
larger than 1%. If GDP falls by 1% relative to the growth path, then the proper
'response' involves cutting the interest rate by 0.5%.
Empirical Relevance:
Though the Federal Reserve does not explicitly follow the Taylor Rule, many
'analysts' have argued that the rule provides a fairly accurate 'summary' of US
monetary policy under Alan Greenspan (1926-), along with Paul Volcker, both past
Chairmen of the Federal Reserve. Similar observations have occurred about
Central Banks in other developed economies, both in countries like Canada,
aswell as New Zealand, that have officially adopted inflation targeting rules,
while in others like Germany where the Bundesbank's policy did not officially
target the inflation rate. Richard Clarida, Jordi Gall, with Mark Gertler
(2000), have cited this observation as a reason why inflation had remained under
'control', while the economy had remained relatively stable (the so-called
'Great Moderation') in most developed countries from the 1980s through the
2000s. However, according to Taylor, the rule was not followed in part of the
2000s, possibly leading to the housing bubble. Specific research has determined
that some households form their expectations about the future path of interest
rates, inflation, along with unemployment, in a way that appears consistent with
Taylor-type rules.
Criticisms:
Athanasios Orphanides (2003), claims that the Taylor Rule can misguide policy
makers since they face real-time data. Orphanides shows that the Taylor Rule
matches the US., funds rate less perfectly when accounting for these
informational limitations, while that an activist policy following the Taylor
Rule would have resulted in an inferior macro-economic performance during the
Great Inflation of the 1970s.
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