What if the foundations of economic policies aren’t as firm as we are led to believe? This was the question on my mind when I wrote part 1 of this blog. I’m returning to it again in part 2, this time with the help of the economist Mariana Mazzucato’s book ‘The Value of Everything’.
Contrary to what economics textbooks might suggest, we did not always think about economics in the way we do now. Indeed, the entire discipline experienced a rebranding in the 20th century. Since its emergence 200 years earlier, the discipline had been referred to as ‘political economy’ and was steeped in politics and philosophy. In the 20th century the term was simplified to ‘economics’ and was discussed in scientific terms (with particular influence coming from Newtonian mechanics). This helped economists claim that their discipline was based on objective facts rather than subjective beliefs. It helped politicians claim that the ‘hard decisions’ they were making were necessary and unavoidable, and this went unquestioned. In this post I intent to question these claims.
Now for some definitions. Ethics forms the foundation of political and economic theories. It is the study of values: what do we value and how do we prioritise values when we must choose one over another? These questions are important for economics. In economics, we try to maximise value, but we can only do that once we’ve agreed what is valuable and what isn’t. Value is the process by which wealth is made and results in tangible things. If an activity produces value, it is productive, hence the need to maximise productivity.
A Brief Economics History Lesson
In the 17th century England was in a struggle with France and Holland for control of the seas. The Mercantilists believed the route to victory was the accumulation of more gold and silver than your national rivals. This could be achieved through trade. The merchants who facilitated this trade, and those who produced goods for trade, were therefore considered productive and their activity to be encouraged. Those that didn’t (such as the clergy, Lords, lawyers and civil servants) were necessary to facilitate value but not valuable in themselves. Agriculture was necessary to provide cheap subsistence but did not need to be encouraged beyond that.
In the 18th century, the Physiocrats believed that land and nature was the source of all value. This includes food as well as raw materials like wool, wood, and minerals. All the subsequent processing of these materials is just transforming the value, not creating it. If too much wealth goes to those who subsequently transform wealth (including industrial labourers), there won’t be enough for those who extract it from nature in the first place, so growth will stop. The greatest criticism is reserved for those who own land but do nothing to create value from it. Wealth gained from land without creating value was described as rent.
During the Industrial Revolution, Classical Economists started measuring value in terms of how much labour went into its production. Adam Smith’s Wealth of Nations is famous for showing how division of labour can allow labour to be used much more efficiently, thereby increasing productivity. Productivity can also be increased by investing more capital in industrial manufacturing. Heavy criticism is levelled at those who hoard their capital or squander it on luxuries. The Physiocrats’ criticism of rent is repeated, now phrased as an inefficient use of capital. Rent represents the additional wealth that can be gained by having a monopoly on an asset, such as owning land which is scarce and needed for production. Government and other sectors which only facilitate manufacturing are not productive in themselves. They are sustained by the surplus wealth created by manufacturing. If government raises too many taxes on manufacturing, then growth will stop.
The purpose of this history lesson is not to say that one of these theories of value is correct. Each theory has its arguments as to what is valuable and what isn’t. The point is that none of them were based on objective and indisputable facts. They were based on ethical judgements of what seemed important at the time, be it trade, land or industrial labour. The same applies to our present theory of value. No theory lasts forever.
Value Today: Marginal Utility Theory
As the industrial revolution progressed, the Classical Economists’ labour theory of value came in for heavy criticism. Karl Marx highlighted the elephant in the room – if value is derived from labour, why was so little of the wealth going to labourers? To avoid a significant transfer of wealth to labourers, a new theory of value was required. This would be the ‘marginal utility’ theory of value, which is still the status quo today. In simple terms, anything is valuable (has utility) if it fetches a price. If someone is willing to buy something, then that thing is valuable. This means that the value of something is subject to and dependant on the circumstances. In addition, the value of something decreases the more it is held or consumed. If you eat five Mars bars in a row, the fifth will give considerably less satisfaction than the first. The same principle applies to production. For example, it could be that the more Mars bars you make, the less it costs to produce each one due to economies of scale.
Economists began to study how the small or ‘marginal’ changes in variables affect a thing’s value. Mathematical models were created to show points of equilibrium. After eating a certain number of mars bars, the value I place on mars bars matches the monetary cost of buying them. Beyond that, there is no incentive to buy or sell more mars bars. However, these models had to make assumptions. The first is that human beings are one-dimensional utility calculators who are always able to make economically ‘rational’ decisions. The second is that buyers collectively determine price without interference, e.g. from monopolies or price fixing.
These assumptions lead to interesting conclusions. For example, all unemployment is voluntary. According to marginal utility theory, people choose to be unemployed because their leisure time is worth more to them than the money they could earn from working. Apparently, everyone works until the value of their remaining leisure time is worth more to them than the money they would get from working. The models also suggest that this market of buyers and sellers will automatically find the optimal price for everything (the equilibrium) and allocate resources accordingly, so interference by government is generally detrimental and inefficient. Government should only intervene when there are market failures. These occur when the market does things that cause detrimental effects (e.g. climate change) or misses beneficial effects (e.g. providing healthcare where there is no opportunity for profit). However, many believe that the inherent inefficiency of government means government efforts to correct market failures are more likely to make things worse.
If value is based on what someone is prepared to pay, it follows that everyone gets what they are worth. This means that any amount of income, no matter how extreme, can be morally justified. Therefore, the Physiocratic and Classical criticism of rent (unearned income) disappears. The entire principle of wealth being earned from activity that is of value disappears, because no activity is objectively valuable or not valuable. Anything can be valuable if someone chooses to pay for it.
Measuring Value: GDP
The marginal utility theory of value determines how nations measure their wealth, known as Gross Domestic Product (GDP). This is important because economic performance is considered the most important success criteria for any government, and GDP is the way that criteria is measured. The surest way for a government to be perceived as having failed is to preside over two consecutive quarters (six months) of falling GDP, otherwise known as a recession. Therefore, governments try very hard to maximise GDP. But what if GDP is measuring the wrong things? That would mean government is working very hard to encourage the wrong things.
GDP includes all goods and services that fetch a price (legally) in the market. This means public services, like schools and hospitals, which have a cost but are provided for free (or less than the cost) therefore have a negative value and reduce GDP. As a result, public services are bad news from a GDP perspective – it is better for those services to be privatised. Also not considered valuable are any services provided for free, including voluntary work, household chores and looking after children. GDP could be increased dramatically if we paid one another to do each other’s laundry.
GDP also does not account for ‘negative externalities’. These are the negative effects of economic activity, such as pollution. If a river is polluted by industrial waste, this is not a problem in terms of GDP. Worse than that, if a private contractor is then paid to clean up the waste, this adds to GDP. GDP also rewards increases in rent. At the time of writing, rents in London have increased by approximately a third in two years. This is catastrophic for many, but excellent news for national GDP. Finally, GDP is not interested in equality. If all wealth were held by one individual in this country, it would not adversely affect GDP. On top of these fundamental issues are the practical problems with national accounting, including availability of data. All this is to say that GDP is an extremely limited measure of whether things are going well or not.
A Message of Hope
Mazzucato ends with a radical message of economic hope. It is not enough to fix isolated issues, such as redefining GDP to measure happiness, or taxing wealth properly. The real task is to come up with a new theory of value, to ensure that the economy is working for the common good. This might not be easy, but it is certainly possible.
The current theory that price determines value and that markets are best at determining prices has caused many nefarious issues. Firstly, we have lost the distinction between value extraction from rent seeking vs. profits from genuine wealth creation. Financial products that amount to high stakes gambling with public money, lifesaving pharmaceutical products sold at vastly inflated prices, and Silicon Valley monopolies like the Google search engine or Amazon marketplace are rarely questioned. Further, this value thinking encourages us to put financial markets and shareholders first and underplays the essential role that government and wider society plays in enabling private companies to operate.
Secondly, the prevailing view that the private sector creates value and the public consumes it discourages potential value creators outside of the private sector. Governments have been taught to do as little as possible and get out of the way of the private sector (except for when a bail-out is needed). When a tech company sells a new product and the rewards go to a handful of shareholders, the preceding years or decades of public R&D investment, as well as the public services and infrastructure also required, tend to be forgotten. In addition, the public sector takes on private sector behaviours even when they are not suited to the creation of public good (such as short-term investing to reduce risk, and investing in already wealthy areas to maximise the rate of return). Thirdly, there are the problems with GDP discussed already, which encourages types of economic activity based on a theory of value which is fundamentally flawed.
We need to understand that ‘markets’ are not free standing and do not exist outside of society. They are part of a wider ecosystem that is sustained by government. Government policies, far from being interventions, are necessary to create and sustain competitive markets. Economists need to look to nature to consider how the private and public sector can create ‘functional partnerships within a mutualistic ecosystem’, rather than ‘parasitic or predator-prey relationships’. The progressive view that markets must be shaped by government policy was shared by Adam Smith, who believed that freedom included freedom from monopolies and rent extraction. Markets can be fashioned so that they work in the interest of the common good.
What direction should the economy go to benefit the greatest number of people? Maximising GDP is clearly not the answer. Obsessing over government debt is also not the answer, for the reasons given in part 1 of this post. Rather than assuming value is determined by marginal utility, decision makers must look to the general public, who must be given a clearer voice through a strengthened democracy, to understand how to direct the economy.
If you are interested in finding out more about this topic, I strongly recommend getting a copy of Mazzucato’s ‘The Value of Everything’, which this blog post is predominantly based on.