3.2 Re-imagining surplus and value: Adam Smith’s musings

The British classical economists, Adam Smith and David Ricardo, shifted the focus from the land to the workshop; from the muddy soil and the horse driven plough to the factory’s grey walls and its noisy steam engines. In contrast to the Physiocrats, they lived in a country where the combined effect of commodification and industrialisation had a head start compared to France or Germany; a head start that caused its political economists to see before anyone else that which the Physiocrats had failed to recognise: that society’s surplus arises from the use of productive labour in any branch of production, not only in agriculture, and that, consequently, surplus is intimately linked to profit.

Adam Smith went to great pains, from the first pages of his Wealth of Nations, to impress upon his reader the idea that the production of pins generates a surplus just as much as the production of wheat does. The realisation that surplus oozes out of every pore of an industrial society. agricultural and non-agricultural alike, placed limitations on the economists’ imagination that could only be overcome conceptually and by means of new analytical categories. For, unlike the wheat surplus, which can be imagined as a large pile in some warehouse (of a size that exceeds the population’s basic human needs), no such visualisation is possible in the case of the surplus resulting from the pin industry. All of a sudden, the theorist had to find some other concept by which to fathom an industrial society’s surplus. British political economists chose the concept of profit and proceeded to identify it with an advanced market society’s heterogeneous surplus.

Their point was simple: if the surplus generated by non-agricultural sectors (e.g. the pin factory) is to be grasped, let alone measured, the profit generated therein is the only sensible indication of a surplus.⁵⁰ Consider a bag of pins selling for one Pound. How much of that Pound reflects the bag’s ‘true’ value, so that we can compute the residual or profit retained by the entrepreneur? Unless we have a theory of value, we have no theory of profit and, consequently, not a clue as to the size or composition of the surplus or of the relative contribution : of labour and capital to its production. So here is the rub: to understand the surplus of an industrialised society in profit terms, one needs a theory of profit which, in turn, requires a prior theory of value.

The deeper reason why a theory of value is a prerequisite for a theory of profit, and thus for an apt measure of surplus, is simple: a modem economy’s total output requires contributions from land, labour, machines and raw materials. In that sense, total income is made up of rent (which pays for land use), wages (which reward workers for their time) and the remainder,- or residual, which is profit and which, naturally, the political economists of the time thought of as the reward to the capitalist for embedding machinery into the production process; for undertaking a risky relationship with bankers (without which they could not have made advances to workers and other suppliers); and generally for organising production.

Profit, in that sense, was seen both as a return to capital and a measure of the market society s surplus. This recognition was tantamount to an acceptance that, before we can talk about the wealth of a nation, we must have something tangible to say about the value contributed by labour to the nation’s surplus as distinct to the value contributed by capital and other factors. The trouble is that the conception of profit both as capital’s value and as a measure of the surplus requires a major fudge. Why this is so is a riddle that will occupy many of the forthcoming pages. For now, we just place a marker to which we shall later refer. Let’s label this marker the riddle of value or economics’ Inherent Error.

It is not the first time we come across this riddle. In the previous chapter, we mentioned Aristotle’s abortive attempt to articulate such a theory and warned of the Inherent Error all economic theories have been carrying in their core to this day. Adam Smith understood the problem well but found, in typically brilliant fashion, a way to bypass it: in quite Aristotelian style,¹¹ he embarked by noting that ‘[i]f 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’ (Wealth of Nations, 1776, I.vi, p. 65). Put differently, Smith’s hypothesis is that in an economy where the only factor or means of production is labour, commodities exchange in proportion to the amount of time required for their production. The so-called labour theory of value was, thus, bom. Alas, what a problematic infant it turned out to be!

Even before stating the basis of his value theory, Adam Smith warned that this early version of the theory was too crude in that it only held for ‘that early and rude state of society which precedes both the accumulation of stock and the appropriation of land’ (Smith, 1776, ibid.). In industrialised societies, commodity production depends not only on labour but also on machines, raw materials, different types of land, etc. The multi-sector and multi-factor world presented a major complication to Smith which is best explained in terms of a simple example. Imagine an economy similar to that of Box 3.1 featuring two sectors: one produces an agricultural commodity, say corn, the other manufactures or machines. Suppose further that the production of 10 tons of corn requires:

•    1 unit of corn (in the form of seed)

•    2 units of labour

•    3 machines

while the production of 10 machines requires:

•    no com

•    1 unit of labour

•    6 other machines

Assuming that workers consume corn (and no machines), the wage must be expressed in terms of the amount of com that workers must be paid for i unit of their labour. Assume, for simplicity, that the wage is such that 1 unit of labour is rewarded with 1 unit of com. Clearly, the inputs into the production of 10 tons of com are equivalent to 3 units of com and 3 machines whereas those necessary for the production of 10 machines include 1 unit of com and 6 machines.

Noting that the production of machines is more machine-intensive than the production of corn, which is more labour-intensive, we reach a worrying conclusion: if we are to stay loyal to Adam Smith’s labour theory of value, we must conclude that the exchange value of

10 tons of corn relative to the value of 10 machines (that is, the relative price of corn) depends on the wage! Let’s see why. According to Adam Smith, given that the cost of 1 unit of labour is 1 unit of com, the relative value of corn ought to reflect the ratio

_ total labour it took to produce 3 units of corn and 3 machines total labour it took to produce 1 units of com and 6 machines

Suppose however that the cost of labour (i.e. the wage) doubles from 1 unit of com to 2 units of corn per 1 unit of labour. Then, again according to Adam Smith’s theory of value, the relative value of corn ought to reflect the ratio

__ total labour it took to produce 5 units of com and 3 machines

¹ total labour it took to produce 2 units of corn and 6 machines

Quite clearly R* and R₂ are two very different values, independently of how much labour has gone into the production of each machine. This means that, if capital intensity differs across sectors, the value of commodities changes as the distribution of income between labour and capital changes (i.e. as the wage rate changes relatively to the profit rate).¹²

Adam Smith, upon thinking the above thoughts, immediately saw the threat to his project posed by the riddle of value. Like all astute storytellers, he wanted to keep to the point and ensure that his story was not more complicated than it had to be. His basic focus was on wealth creation and its determinants. It was a narrative on what, today, we refer to as a theory of economic growth', a theory of the dynamics by which society’s wealth, or surplus, grows. Smith was: keen to get on with the story of how the combined benevolence of the division of labour and of competition promises to bring about a prosperous society. But the simple calculation in the previous paragraph threw a spanner in the works of the narrative.

To see this from a slightly different angle, recall how the Wealth of Nations famously begins with an account of the division of labour spearheading the growth of Britain’s economic surplus. In his perceptive eye, both the division of labour and the resulting growth were fuelled by the elixir of competition. For, it is competition among egoistic entrepreneurs which:promotes the social interest precisely because the entrepreneurs are so indifferent to whatever that might be.¹³ Moved solely by the call of private profit, and speared on by their competitors' perceived actions, capitalists are forced to drop prices to an absolute minimum, employ the best division of labour possible, purchase the more productive machinery and

Box 3.3 Smith on capital accumulation

Parsimony, and not industry, is the immediate cause of the increase of capital. Industry, indeed, provides the subject which parsimony accumulates. But whatever industry might acquire, if parsimony did not save and store up, the capital could never be greater. Parsimony, increasing the fund which is destined for the maintenance of productive hands, tends to increase the number of those hands whose labour adds to the value of the subject upon which it is bestowed. It tends, therefore, to increase the exchangeable value of the annual produce of the land and labour of the country. It puts into motion an additional quantity of industry, which gives an additional value to the annual produce.

Adam Smith (1776), Book II, chapter iii, p. 337

reinvest all accrued profit back into the enterprise, aware of the cruel fact that their profits are unsafe and that the only insurance policy against future bankruptcy is the perpetual reduction of average costs through unstoppable investment into cost cutting technologies.

Karl Marx, in his usual swashbuckling prose, offered the following faithful interpretation of Smith’s more measured turn of phrase:

Accumulate, accumulate! That is Moses and the prophets! Industry furnishes the material which savings accumulate.¹⁴ Therefore, save, save, i.e., reconvert the greatest possible portion of surplus-value, or surplus-product, into capital! Accumulation for accumulation’s sake, production for production’s sake: by this formula classical political economy expressed the historical mission of the bourgeoisie, and did not for a single instant deceive itself over the birth-throes of wealth.

(Marx (1867 [1909], p. 652)

Thus, in Smith’s story, competition leads to cheap and abundant goods. With profit from arbitrage (i.e. from buying low and selling high) rendered impossible due to price undercutting between ruthless entrepreneurs, prices go into free fall. As his background was the Britain of the late eighteenth century, rather than Russia since the 1990s, he thought that rivalry was no longer about duels that end in a pool of blood but market stratagems for splashing red ink all over the competitor’s accounts.¹⁵ And price cutting was the weapon of choice. As prices gravitated towards what Smith called their natural leve! (another term for the absolute minimum price that is given by the lowest possible per unit cost), society would be blessed with the best remedy for poverty possible: minimal prices and maximum quantities! Miraculously, as if by the providential guidance of some invisible hand (Wealth of Nations, IV, ii, p. 456) which put society on a course of less moralising, less hunger, less deprivation and, ultimately, greater prosperity. However, if the distribution of these gifts of competition were to change (e.g. if the proportion of the surplus that went to the working class were to rise or to fall), Smith would have to concede that the value of commodities would also change (recall that ratios R, and R₂ differ). But then how could he claim that competition succeeds in keeping prices at their ‘natural’ level?

This complication was clearly one that Smith could do without. So he did what any economist worth his salt does: he assumed it away! More precisely, Adam Smith assumed that the wage share of the surplus, and thus the distribution of income between workers and capitalists, does not change while the economy is growing. In this way, he kept his theory of growth separate from his theory of value.¹⁶ His manoeuvre around economics’ Inherent Error came at a price: a silent admission that his narrative cannot explain the wealth of any nation whose social classes experience fluctuations in their share of that wealth. Nevertheless, to his credit, Smith did not pretend to have produced an economics of mathematical exactness and general application. He told a story about wealth creation and let his readers decide whether, and to what extent, it made sense. If only modern economists had the same integrity they might have avoided spending the last four decades cloaking the profession’s Inherent Error in multiple veils of pseudo-scientific complexity of the type that contributed so generously to the Crash of2008.

3.3 Value and the social power of non-producers: David Ricardo’s anxieties

David Ricardo was unimpressed with Smith’s solution to the value question. Writing in the midst of the Napoleonic wars and their aftermath which disrupted corn imports and raised corn prices immensely, Ricardo had witnessed, right in front of his eyes, large-scale changes in the very distribution of wages, rent and profit which Smith had assumed time invariant. Corn prices had risen, subsistence wages paid in corn had followed suit (so that workers could continue to subsist) and that rise had cut deeply into the capitalists’ profit. Even worse, these changes, on the back of their negative impact on investment, had clearly retarded overall economic growth causing one of capitalism’s early recessions.

Ricardo’s anxieties may have been initially caused by the disturbing observation of landowners gathering ‘undeserved’ wealth and by his outrage at their campaign to impose import restrictions after the war had ended; a campaign whose cynical objective was to extend the gentry's wartime windfall well into peacetime. However, his worries soon acquired a more abstract, theoretical complexion. Taking Adam Smith’s narrative on economic growth to its natural conclusion, he predicted that com prices, and therefore subsistence wages, would rise inevitably; even in the absence of wars or tariffs. The reason? As economic growth boosts employment, and more workers require more corn just to show up at the factory gates every morning, more and more land would have to be cultivated. Ergo, land of decreasing fertility would have to come into production, thereby increasing not only the cost (and thus the price) of corn but, more worryingly, amplifying the difference between the cost of the most and least productive land as well.

This differential (between the highest and lowest cost of corn production) is due to physical attributes of the land (i.e. the different fertility of different plots of land) that neither the division of labour nor the power of competition can do anything about. Indeed, if anything^ it is a differential that would increase in time as the division of labour advances, competition intensifies, the economy grows and, ultimately, the demand for com swells. Ricardo’s anxiety was that, as this differential expands (i.e. the more relatively infertile land is ploughed to meet the population’s expanding demand), an increasing share of the surplus would be siphoned off into the pockets of the landlords and out of the virtuous circle of wealth creation.

Suppose, for example, that the cost of producing one unit of corn on fertile land belonging to Lord Scrooge is $10 but that only a limited output Q is possible on his land. If demand is low enough to be satisfied by production on land similar in fertility to Lord Scrooge’s, competition between corn producers will keep the price hovering around $10. However, as demand expands, less fertile land will enter production, say at $X per unit of corn (with X>10). Growth means more demand and more demand means a rising X - 10 difference, which is fantastic news for Lord Scrooge and his ilk but a burden on everyone else. The Lord’s net revenues, given by $(X - 10)Q, rise at a rate which is analogous to the rate of increase in the price of com, $X, while, all along, his cost remains the same. This increasing gap diverts towards Lord Scrooge an increasing share of the surplus which Ricardo called rent.

But what is wrong with the rich landowners getting richer? Why is it OK for the factory owner to make a profit but problematic when a landowner retains rent? Because profit and rent have different natures and play different roles in society, bellows Ricardo. While both profit and rent are residuals left over after costs have been met, rent has nothing to do with investment, innovation or entrepreneurship but, instead, constitutes a windfall for the landowner which he owes solely to the accident of birth that bestowed upon him property rights over the most fertile land. So, profits and rents are two wholly different species of economic variable, even if identical from an accounting point of view. Turning to their different roles, profit incites its claimant (the merchant-entrepreneur-industrialist) to re-invest it whereas rent does no such thing: while rent is a windfall safe from competition (since no amount of innovation by Lord Scrooge’s competitors can produce land of equal fertility to his), the industrialist’s profit is constantly threatened by wily competitors scheming to eat into it with new products, lower prices, better quality, etc.

So, fear of bankruptcy motivates the industrialist to plug his profits straight back into productive use (better technology, products, division of labour, etc.) while Lord Scrooge, untouched by the angst of competition, hoards his rents or spends it on trinkets and activities, such as patronising the universities and the arts, which do nothing to boost the economy’s productive powers. Rents, in this Ricardian perspective, are a brake on growth with a braking power that gets worse the stronger the economy’s productive forces. From an ‘organic’ viewpoint, the aristocracy are acting like a reckless virus which attacks its hosts with such virulence that it runs the risk of becoming extinct as a result of killing them all. Unable to limit their ill effects on the healthy organism on which they are dependent, landowners will continue to harvest rents until capitalism’s dynamism withers.

That was Ricardo’s nightmare. Its lasting legacy is an important contribution to political economics which highlights the chain linking growth, value and the distribution of income between those who produce and those who have disproportionate social power over the output. As it turned out (see below), Ricardo’s valiant plunge into the growth-value-distribution nexus pushed him deeply into the messy entanglement that we, in the previous chapter, foreshadowed as economics’ Inherent Error. And yet Ricardo’s economics, while messier than Smith’s, packs important insights for our time; a time when the world’s surplus is harvested to such a great extent by various groups (oil barons, bankers, financial engineers, etc.) whose claim to have contributed to its creation is at least as tenuous as that of the landowners whom Ricardo so valiantly opposed.

Our foray into Ricardo’s deeper economic thinking thus begins with his hunch that when rents rise, wages must follow suit, cutting into profits, depressing investment and capital accumulation and, subsequently, trimming down, if not reversing, economic growth. To make his point in a consistent manner, Ricardo took a leaf out of the Physiocrats by evoking a fictitious single commodity economy. The so-called corn modell Why was corn placed at the heart of his model of capitalism? While it could have been some other good, corn had its advantages: first, it constituted the basic staple diet of the British workers at the time and the battleground on which landowners were fighting a political battle against the rest of British society for the preservation of their privileges.¹⁷ Second, in view of corn’s political and dietary centrality, it was hard to imagine the growth of Britain’s surplus without imagining a growing com surplus. And because labour was an input into all produced commodities (agricultural, industrial, services, etc.), with the wage its reward, expressing the wage in terms of the amount of com each worker would take home weekly made it possible for corm to be conceived of as an input into all types of economic activity. Last, corn’s capacity to be its own input (with corn seed being necessary for future com output) allowed a parallel story to be told, also based on the corn metaphor, about capital and its accumulation (i.e. a theory of investment).

Compare the allegorical utility of com as a metaphor for capital with that of, say, gold. In principle, there is no reason why gold cannot take centrestage, displacing from our imagination the stockpiles of food, wine and honey with which heaven had been traditionally associated. Although Midas’s plight offers a poignant warning against this displacement, it came from a bygone era that preceded commodification and which had been sceptical of the worship of profit. The emergence of market societies from the ashes of the ancien régime made possible a freshly legitimate yearning for money as an end-in-itself the best and most graphic depiction of which is Disney’s Scrooge McDuck and his ecstatic plunges into a vast pool of golden coins. Nevertheless, despite the rise of Mammon as a legitimate deity and the new possibilities for imagining gold stashes as the stuff of heaven, corn could not be bested as the political economists’ basic commodity. For, it was not only impossible, even for Scrooge McDuck, to live without it, but it also possessed a mystical capacity that no gold, platinum or diamond could muster: corn required corn (in seed form) for its production while gold and the other symbols of ostentatious wealth could be produced without a smidgeon of their own substance.

Gold was, indeed, dug up by miners who depended on com, hence gold production necessitated com as an input; but com did not need gold at any stage of its production. Generally, corn seemed to enter (through the wage) into the production of every commodity, but not every commodity entered into the production of corn. In this view, com was deemed the basic commodity whose production determined how lucrative gold digging might be. This unlikely dependence of the gold industry on its far less glamorous corn counterpart made perfect analytical sense once it was realised that the point about a basic commodity, like corn, is that the rate of profit extracted by its producers determines the rate of profit in the Other sectors (Including the gold mining sector). Meanwhile, the profit rates of most other sectors (e.g. that of gold) were immaterial to the rate of profit in the corn sector. It was in light of this asymmetry that the corn sector came to be seen as the crucial sector and its product could be imagined as a form of all-purpose currency. In other words, choosing com as his basic commodity gave Ricardo an analytical fulcrum. It allowed him to express the profit rate in natural terms bypassing the problem of value in computing the profit rate. Since the-profit rate was - through competition - uniform in all sectors of the economy, he could use the profit rate in the agricultural sector as a standard to compute the values in other sectors of the economy.

The British political economists were enamoured of the corn model because it allowed them to highlight the conditions for a sustainable (or reproducible) economy and, by extension, the conditions under which an economy grows. Since the overall output of com cannot be less than the sum of the amounts needed (a) for replanting plus (b) for paying the wages of those who work throughout the economy, corn promised to help measure the surplus without assuming (as the Physiocrats had done) that only agriculture is productive and responsible for a market society’s surplus. In short, com promised to deliver the Holy Grail of economic thinking: a combined theory of the surplus (and its growth or accumulation) and a theory of value.

To see how that combined theory was put together, let us begin with a feature of the corn model which greatly simplified any analysis based on it: it left no room for uncertainty, save that caused by weather fluctuations. More precisely, in an economy where all payments are made in com, and corn is at once a consumption good and a capital good, it makes no sense to pile com up (except as a precautionary measure against the possibility of drought or flood). Abstaining from both eating corn and replanting it only makes sense if one is worried about weather fluctuations. So, an uncertain weather aside, any reduction in consumption (i.e. any savings) leads the com economy to increase investment (in the form of more corn seed to be ploughed back into the land). In this sense, the com model gave short shrift to any worries that capitalists might hoard profit (i.e. neither consume) instead of investing it. In a com economy, saving is, therefore, tantamount to investment and abstinence is synonymous with growth: a simple conclusion which fitted nicely into David Ricardo’s theoretical project of portraying, and studying, capitalism as an economy where the only threat to growth is rising nominal wages due to the encroachments of rent and to the parasitic landowners who claim it.

The simple com model in Box 3.4 captures Ricardo’s core theory of growth and of the distribution of income.^iS Its political-cw/n-economic implication could not be simpler: in a competitive economy, the only impediment to growth is a rise in the wage share of the surplus.

And since workers could not raise wages above subsistence (at a time when masses of unemployed people roved the land and no trade unions or pro-labour government intervention was thinkable), the only threats to growth were increases in the price of wage goods, like grain, and the concomitant hike in landlords’ rent. More generally, Ricardo’s scheme leads to the conclusion that an increase in real wages reduces net com savings (since the workers consume more corn) and pushes down both capital accumulation and the profit rate. This is the simple message of the corn model where the distribution between wages and profits governs the pattern of accumulation and growth.

Box 3.4 Growth and the distribution of income in a pure com economy

In an economy where corn is a one-commodity show (e.g. it is at once an output, an input and the currency in which savings, investment, wages, rents and profits are measured and advanced), there is no room for money. To make the analysis even simpler, suppose that corn is the only commodity; and that we have a one-sector economy. Let K be the stock of the economy’s com capital and suppose that S is the com saved at the end of a period, while D is the quantity of corn that needs to be set aside as seed for next period just to keep corn stocks steady (in more contemporary parlance D is the amount of com that must be put aside to cover for the com capital’s depreciation. We have fully circulating capital and the rate of depreciation is equal to I). What happens then is that S is invested (since there is no sense in hoarding corn that no one is eating), and constitutes the net increase in com capital K. In short

S = AK = I or .S’, = K_t - K_l__i = I, where I is investment. Growth, in this economy, means a growing stock of capital K which, inescapably, produces a growing surplus.

Taking the analysis further, it is easy to show that, in this pure corn economy, first, profits and wages move in the opposite direction and second, the rate of profit equals the rate of capital accumulation (or the rate at which capital K is increasing).

Letting,

•    Q be corn output

•    a be the quantity of corn produced per unit of com capital

•    L be the number of labour units involved in com production

» X = L / K be labour per unit of com capital (i.e. the amount of labour that each unit of capital requires to work with in order to be productive)

•    w the wage per unit corn (i.e. the wage, in com, that the worker must receive to participate in the production of one unit of com). We assume that workers do not save and that they consume their wage.

•    w = xvL the wages (in com) of all workers put together

•    17 the total profits (expressed also in corn) by the capitalists who organise production. All the profits are invested.

•    7t = FI IK the ratio of total profit to total capital; that is, the capitalists’ rate of profit, we establish the following relations between the different quantities of corn:

Q = aK

(3.1)

(3.2)

Q-W + D + n= XwK + D + n

The meaning of equation (3.5) is straightforward: the rate of profits n on corn is given by the difference between the output per unit of corn capital a, the wage cost per unit of labour applied to corn capital Aw, and the rate of depreciation taken as being equal to 1 because of the assumption of fully circulating capital. Equation (3.5) describes the net surplus of corn per unit of corn capital. The equation defines also the pattern of the distribution of income between the rate of profit and the wage rate. It shows that, for any given value of a and A, the rate of profit moves in the opposite ^direction to the wage rate, which, indeed, carries a negative a sign.

Now since all surplus (profits) is saved and invested, and since all wages are spent on consumption S ~ I = FI, and

SIK - I / K - II / K    (3.6)

TI i K is k , the rate of profit, and I/K is net investment over corn capital, which, :by definition, is the increase in the capital itself. Capital increases only by means of investment.

Since S = AK = I, (3.6) becomes

k = 77 / K ~AK / K = g , where g is the growth rate, or

The rate of profit is therefore equal to the rate of increase of capital, that is, to the rate of growth of capital or, in a different terminology, to the rate of capital accumulation. The conclusion is that if all profits and no wages are saved, the rate of profit is equal to the rate of growth.

Conclusion

As the total profit 77 is analogous to capital K, the rate of profit n - 77 / K - (a - Aw -1 is inversely related to the wage rate w while positively related to labour productivity improvements (i.e. to reductions in A) and the rate of profits is equal to the rate of growth.

The pressing question however is: how does this theory extend to multi-sector economies? Clearly, a theory of growth in which the profit rate is assumed to equal the rate of capital accumulation will simply not do in a multi-sector, or multi-commodity, world. The reason is twofold: (a) there are now many different profit rates (one per sector); and (b) there are relative values, or prices, in dire need of explanation. How did Ricardo deal with this riddle of value while maintaining a theory of growth?

Influenced by Smith, David Ricardo claims that competition ensures four things at once: first, it helps equalise profit rates across all sectors.¹⁹ Second, it does the same with wage rates.²⁰ Third, it causes capitalists to save all profits and invest them in capital goods (e.g. machinery, innovations) so as not to fall behind the competition and end up bankrupt due to higher average costs. Fourth, it ensures that the prices of all commodities gravitate towards their intrinsic (or true) values and that these values are proportional to the amount of labour expended in their production.

Note that these four feats attributed to competition assumed that the economic system operated on the basis of a long-run Newtonian gravitational field towards stationary positions at which all the forces of competition would have worked themselves out, thereby bringing about the rule of the cost minimising techniques and, with it, the rule of uniform rates of profit. In this way, it was assumed, day-to-day variations in the conditions of supply and demand are just incidental to the fundamental laws of‘economic gravity’. The separation between the determination of the values of commodities and the factors governing the distribution of income between wages, profits and rents makes the latter depend on the relative ‘power of the combatants’, to use a phrase by Karl Marx. In Ricardo’s own words, the crucial element of social conflict lies in that ‘the interest of the landlord is always opposed to the interests of every other class in the community’.²¹

To sum up, the first three feats Ricardo had ‘expected’ of competitive forces (namely, to equalise profit and wage rates plus to instill in capitalists a desire for re-investing all profits/ savings) could be seen as plausible and, in any case, underpinned his theory of growth nicely. But things got sticky with the fourth feat: his expectation that commodity values would reflect the ratio of minimum labour inputs necessary for their production could not be made consistent with the rest of his theory. Values, it turned out, were bound to depend on the distribution of income between wages and profits unless all sectors and production processes are characterised by identical capital intensity.²² When they are not, we are back in the grip of economics’ Inherent Error whose lineage goes back to Aristotle and which we discussed in the previous chapter; an error which is reproduced, as we shall argue repeatedly in this book, whenever the theorist tries to embed a consistent theory of value within a broader theory of capitalist economic growth; an error which, in recent decades, has aided and abetted the policies and strategies that played a hand in bringing us the Crash of2008.

3.4 Relative capital intensity and economics’ Inherent Error

Adam Smith and David Ricardo shared a conviction that the Good Society could only be brought about by the automation and rationalisation of production, by a clever division of human and of mechanical labour, and by unfettered competition that would keep transforming greed into good. In that mindframe, it was thought that society’s interests were served best when capitalists retained the right to claim the residual leftover once the factors of production had been paid enough to keep them in production. The reason? Because they would not hold on to it for themselves! Competition, Smith and Ricardo thought, would guarantee that capitalists would have no option but to plough the residua! back into the growth cycle, fearful of the vengeance of the market if they did not. The outcome would be bigger and better machines, a cleverer organisation of production, extra research in new technologies and products, development, innovation, etc. All powers to capital so that capital can produce more for less.

The two great thinkers differed on one small detail which, remarkably, was enough to drive a wedge between them: whereas Smith was happy to accept that the distribution of income between the social classes was more or less stable, Ricardo was not. Eager to sound a warning about the deleterious effects of rising landlord rents, he had no alternative but to study the effect of a variable income distribution on growth. But that eagerness unhinged his theory of value; a predicament that could only be alleviated if one could argue the unarguable: namely, that the intensity with which machines contributed to output was the same in all of the economy’s sectors.

Ricardo’s corn model was, in summary, a commendably concise theory which helped him make his case against the economic malaise that was the landlords and their increasing power to extract rents. However, any simple model⁷s worth is tested according to its capacity to stay afloat in the high seas, that is, in Ricardo’s case, when there are many commodities and not just one kind of input. Thomas Robert Malthus challenged him precisely on that and David Ricardo responded with the book which was to make him famous: on the Principles of Political Economy and Taxation, first published in 1817.²³

Malthus’ challenge was to point out (see also note 13 in this chapter) that for the labour theory of value to work, each commodity had to be produced by the same technique of production involving the same proportions in the use of the various inputs. Ricardo replied with an attempt to extend the corn model to a system with many commodities (see Box 3.5 for the simplest variant). It is, alas, impossible to conclude that his extended model answered Malthus’ critique convincingly. The end result is another special case involving identical techniques of production (machines to labour ratios) in every sector of the economy.²⁴ The best Ricardo could do in response to Malthus was to suggest that his theory was approximately correct. We doubt that this is a sufficient answer; as, we suspect, did he.

Box 3.5 On the possibility of unproductive labour

The extended corn model featuring a luxury good but no machinery¹

Consider an economy comprising the usual three social classes (workers, landowners and capitalists) and two sectors: one producing com (the basic commodity²) the other gold. Gold is brought to the earth’s surface by miners who are paid subsistence corn wages The landowners own all the land, including the mines, which they rent to capitalists, some of whom run the farms while the rest operate the mines. Meanwhile, corn is produced by agricultural workers and is both a consumption and a capital good: as a consumption good it is the currency with which both gold and labour are exchanged. As a capital good, it takes the form of corn seeds sown in the soil and functions as a means of further corn production. At the year’s end the economy’s aggregate corn harvest is divided between:

(a)    Rent, which is the part of the harvest retained by the landowners who use it to feed themselves and to buy the gold they covet from the capitalists operating the mines.

(b)    Wages, which is the part of the harvest paid to workers (by the capitalists running the farms) and to the miners (by the capitalists operating the mines).

(c)    Depreciation, which is the part of the harvest that must replace the seeds sown in the soil the year before.

(d)    Investment, or the part of the harvest to be ploughed back into the soil so that the next year’s harvest is larger than the present one/

In this Ricardian economy, workers and miners subsist on corn wages paid by capitalists. Competition between capitalist farm operators guarantees that they will invest all residual corn (i.e. the profit left over after wages, rent and depreciation are accounted for) back into producing more corn next year. As for the mine-operating capitalists, who can only invest by hiring more labour (since this model features no machine tools), they may end up with surplus gold, which will adorn their homes. Thus, all actors will end up with enough corn for subsistence purposes but gold will pile up only in the homes of the landowners and the mine operators.

Suppose now that at the end of each year gold turns into coal dust and is blown away by the wind, as it did in medieval fairytales according to which children, offered gold by visiting night fairies, were left disappointed in the morning with black dust slipping through their fingers. Interestingly, this ritual gold carnage should not affect the system’s capacity for economic growth in the slightest! If the harvest generates a com surplus, due to continued investment in com capital, growth will carry on (see Box 3.4) and the harvest will be able to feed more and more miners so that gold mining can also be expanded. In this sense, the above is a purely physiocratic model in which economically meaningful surplus comes solely from the land. Of course, things would be different if, instead of gold, corn withered into thin air at the end of each period. Then society would just die. It is in this sense that com is a basic commodity while gold, despite its infinite and mystical desirability, a mere luxury.

The model above is important because of a very contemporary issue it brings to the fore. Admittedly, post-war consumerism has ensured that there is no such thing as a basic commodity today. Wages pay not just for bread and ham but for a huge array of consumption goods, including items that have till yesterday been branded ‘luxuries’. However, the parallel question ‘Which type of labour is productive and which not?’ is as relevant as ever. The gold-versus-corn allegory suggests that labour is productive not when it is hard or glamorous (recall that, in the above model, gold mining is economically inessential labour even though it may well entail backbreaking work and produce a coveted item) but when it contributes directly to the reproduction and expansion of society's capital. In this view, the economic importance of different types of work has nothing to do with its financial rewards, social status, the skills required to perform it or the fatigue it causes the worker. Just like in our simple model, the work performed in the gold sector was irrelevant to surplus generation, even though it was gold, not com, that adorned the houses of the rich and powerful, so too certain contemporary endeavours may be irrelevant to genuine wealth creation even if they are bathed in the limelight and feted as hugely important, sophisticated and glamorous. It is even conceivable that the mighty financial sector, along with the glitzy worlds of marketing and fashion, are parasitic to the genuine business that generates wealth.

In conclusion, whether an economic activity is productive or not depends on the ways in which it aids or hinders the multiplication of productive capital - a sobering

thought at a time when bankers’ bonuses, extravagant marketing campaigns and financial engineering are defended as essential lubricants in the wheels of contemporary capitalism. Notably, this is a conclusion that, as we shall see, ‘modem’ mainstream economics has no stomach, or mind, for. It constitutes one of those precious lost truths that were (as we argued in the previous chapter) once better understood.

Notes

{ The example in this box is inspired by Pasinetti (1983).

2    The notion of the basic commodity has been fully developed by Piero Sraffa (1898-1983) in Sraffa 1960. That book rekindled the critique of the theory of capital that became fashionable at the end of the nineteenth-century - i.e. neoclassical capital theory. Sraffa’s contribution effectively rehabilitated classical political economics which, until then, had been referred to mostly as a sort of precursor of neoclassical theory. Sraffa’s book put paid to a number of appalling misconceptions: e.g. that Adam Smith’s reference to the invisible hand was a justification for the theory of perfect equilibrium in all markets simultaneously (i.e. of some General Equilibrium), or that Ricardo’s argument about land of diminishing fertility was a form of the neoclassical theory of diminishing marginal productivities (see Chapter 5 below). See also our discussion of Sraffa in Section 4.11 of the next chapter. See also, Eatwell and Panico 1987, J.C Wood (1995), Roncaglia (2000), Kurz (2000). For an admiring view from the opposition see Samuelson 1987.

3    Here we assume that since all production is based on labour and corn is the only capital good, investment only happens in the corn sector.

Box 3.6 Ricardo on the machines vs jobs debate

In the third edition of his Principles, published in 1821, Ricardo (1817/1819/1821 [1951], chapter XXXI) added an important chapter ‘on machinery’ and addressed a question that still tries our minds: do machines cause unemployment by displacing labour? His cue came from a workers’ movement known as The Luddites', an early type of industrial terrorists who destroyed or sabotaged machines in a bid to help workers keep their jobs. Initially, Ricardo had denied that machines posed a threat to employment and advocated the theory of automatic compensation (i.e. that new jobs would be created to take the place of jobs displaced by machines). However, in the 1821 edition, he accepted that such an automatic compensation was unlikely to happen. Interestingly, a strong defence of Ricardo’s 1821 position, that machines can reduce wages and output, has been put forward by the leading neoclassical economist of our times, Paul Samuelson (1988 and 1989) in two articles entitled, respectively, ‘Mathematical Vindication of Ricardo on Machinery’ and ‘Ricardo was Right!’.

3.5 Epilogue

Since its inception, physics has undergone many paradigmatic changes, from Euclid to Newton, from Newton to Einstein, from Einstein to the latest attempts to tell a unified story involving energy, quanta, gravity and the mysterious particles contributing to dark matter. With each of these ‘shifts’, physics moved on from its early simplistic forms to more complex explanatory structures, while retaining the truth of its earlier paradigms. The history of economics could not have been more different.

The corn model .was-political economics’ first serious stab at answering, within a single theoretical framework, questions involving (a) economic growth, (b) exchange values and

(c) the distribution of income. It was, in effect, a single sector model of capitalism. It is still with us! In all its incarnations over the past two centuries, and despite the remarkable technical advances incorporated into economics since Ricardo’s times, the corn model remains today central to the way economists think of a growing capitalist economy, often unwittingly.

Economics is, thus, still in the clutches of its original paradigm; of its Inherent Error. To this day, the only way we can combine a theory of growth with a theory of value is either by committing intellectual crimes worse than those of Adam Smith (who assumed incredulously a stable income distribution) and David Ricardo (who presumed an identical capital intensity in every sector) o/- by sticking to the (almost physiocratic) single sector model.

The above is, of course, a controversial claim that must (and will) be substantiated in the following chapters. Our simple point for now is a recapitulation of Chapter 2’s main theme regarding economics’ penchant for lost truth and Inherent Error. The Inherent Error we have discussed: it began with Aristotle, survived the Physiocrats, moved into the corn model and, as we shall see, continued to lurk in the theories of Wicksell and in the underpinnings¹ of Ramsey’s models. After the Second World War, it resurfaced intact in dynamic theories of growth (such as those of the Roberts Solow and Lucas) and, indeed, lives on within all that passes today, quite scandalously, as ‘contemporary macroeconomics’. If we are right, and this is genuinely an Inherent Error, no economic theory can be generalised to a complex multi-sector world resembling our own. This means that economics might be intrinsically; ill-equipped to speak to the concrete complexity of the social and historical embeddedness of economic variables,

Box 3.7 The disappearance of money

If we are right in claiming that contemporary macroeconomics is stuck in a single sector (or com model) mindframe, our theories of money (and by extension finance) are suspended in mid-air. Celebrated economist John Hicks (1985) explained why succinctly. In this type of model, he writes, *[t]here is no problem ... about the transmission of saving into investment, for in that model there is no money. Indeed, there is hardly any exchange. One would be quite entitled to think of the landowners (or capitalists) into whose possession the harvest comes just piling it up in their storehouses; then doling it out to those whom they employ, productively or unproductively. Those employed are thus paid for their services, and that closes the matter as far as they are concerned. If they are paid in money, they spend the money on ‘corn’ consumption, the money just comes back where it was without making a difference. There does not seem to be any harm in leaving [money] out.’ (Hicks 1985, pp. 34-5) It seems that an escape from single sector economics was always a strong condition for having anything sensible to say about really-existing capitalism. Alas, such an escape is easier imagined than accomplished ...

When as economists we turn a motivated blind eye to this predicament, economics turns dangerous. At best, our theories become glorious irrelevances whose best contribution to humankind is as a warning against consulting economists when formulating socio-economic policies. This is such a pity. For as we have seen in this chapter, despite its intrinsic incongruity, political economics has a unique handle on important truths, for example, the conclusion in Box 3.5 that labour’s contribution is linked to the extent that it aids the formation of capital. Economics’ dogged refusal to recognise the Inherent Error in its bosom leads to the loss of these crucial truths which it, alone, can unearth.

Somewhere around this juncture, the reader may well ask: why can we not retrieve lost truth and add new layers of knowledge upon it, bypassing all error and improving economic theory until it becomes socially useful? A noble sentiment no doubt but, alas, a sentiment bound to crash upon the shoals of the economists’ iron-clad commitment to be 'scientists’, complete with a panoply of consistent models. An aspiration to be scientific is, of course, commendable. Who would censure an ambition to be Galileo as opposed to some pontificating ideologue? However, the aspiration to be for economics that which Galileo and Newton were for natural philosophy (as physics was called back then) threatens to produce, instead of enlightenment, a religious fundamentalism-with-equations. The reason is that, unlike in physics, economists have to reckon with an Inherent Error that ‘natural scientific’ inquiry is immune to (thanks to Nature’s indifference to our musings). It is an error caused by a definite feature of human, market societies: value can never be independent of the distribution of social power over the surplus produced by human labour and ingenuity. Social power is determined by our valuation of things, of people and of their ideas and, at once, determines these values. This infinite feedback between value and power lies at the heart of economics’ Inherent Error, ensuring that all economics that overlooks it, or that tries to ‘solve’ it by technical means, is bound to produce a profoundly misleading theory of society. One needs to have no Cassandra-like abilities in order to imagine what might happen when such a theory informs the policies of central banks, the fiscal and industrial policies of governments, the financial regulators’ practices or, indeed, the curricula of economics graduate schools.

To conclude, this book argues that overcoming economics’ Inherent Error and procuring a logically consistent theory of value within a useful theory of growth is more than just difficult. It is impossible! We saw how, in early political economics, this conundrum forced Smith to a fudge involving income distribution and Ricardo to a sleight of hand, namely relative capital intensities. In the following chapters, we shall recount the main nineteenth-and twentieth-century responses to the Inherent Error and the new ploys economists used to overcome it. The only reason for telling this story is because it is important from our current twenty-first-centmy perspective. Many of our contemporaiy troubles stem from the way economic models metamorphosed over the past two centuries without shedding the Inherent Error from their foundations. With every such metamorphosis, the models gained in analytical and technical complexity but lost some important truth better understood by earlier iorms of economic thinking. Truth was increasingly sacrificed for more elegant clothes, the new knowledge produced proved less and less meaningful and the policies based on them destabilised an already unstable economic system.

Paradoxically, this steady erosion of meaning and truth coincided with the profession’s success at augmenting its powers of persuasion. Persuasion in the field of political economics, it seems, depends more on the models’ form than its content or effect. Clothes matter more than that which they adorn. And economists have proved to be master designers, accruing considerable discursive success which, in turn, caused them to grow in confidence, to believe their own rhetoric more readily, and to end up peddling knowledge derived from a variant of the corn model to a world whose complexity they cannot begin to fathom. Worse still, the ‘insights’ projected through economics’ distinctly single sector lens eased decision makers towards policies and practices that suited them and their constituencies nicely, policies not unlike those which led us to the Crash of2008.

And when the crisis that the models could not have predicted happened, the same models were used to impart ‘new’ wisdom on what to do next. Unsurprisingly, the remedy offered was worse than the disorder they helped cause in the first place. What else could we have expected of a ‘science’ built upon an Inherent Error which it is hell bent to overlook?