Marginal Ideas

 

No Factory Works

The lesser criticism arises from my reading of Garry Wills' Inventing America. In discussing the avid interest Enlightenment people had in science and technology, Wills frequently mentions their fascination with machines. This was the result of Newton's physics, which offered a reasonably addictive explanation of the world as a pin ball machine. The mechanistic view originating in the Enlightenment continued to prevail until Einstein's Relativity. In the end, it took Twentieth Century scientists including Bohr, Heisenberg, Pauli, Fermi, Dirac, Schrödinger and others to produce Quantum Mechanics, which destroyed the philosophical and physical basis of the Newtonian system. In turn, that allowed discovery of the Big Bang, ancient life, pre-human hominids and all the other things which characterize modern learning. Until probability and Darwinism reigned supreme, people were trained in mechanistic ideas which they generalized and applied to everything.

Adam Smith and the Jeremy Bentham were children of the Enlightenment, living in the midst of the early Industrial revolution, Watt's steam engine and the inventions of the Factory and Railroad. At a stroke, a few brilliant Scotch Technologists broke the ancient Gordian Knot: who would do the work? Machines replaced human slaves. So early capitalist economics was naturally based on what happened in those primitive factories; e..g, Adam Smith's famous description of pin making. The Railroad made possible national and international markets; i.e., mass markets. For the first time in human history, the economy could be larger than a village or county due to the factory and the ability to transport goods to remote buyers. That fact is still represented in the Dow Theory of stocks, in which the Industrials and Transports are two major factors.

Bentham and Smith were at loggerheads over the price mechanism, the theory of value. The different theories were eventually formalized by Ricardo (for Smith) and JS Mills (for Bentham), but reconciled in the modern neo-classical theory of economics. What Libertarians (neo-classicists) prefer to believe is that the Smithian model in fact produces the Greatest Good for the Greatest Number. Thus, the Benthamite ethical criterion is implicit in neo-classical economics. Conveniently, this closes the loop about the successful being the Chosen People, as capitalist success (retroactively) proves the moral worth of the endeavor. Capitalism is Right because it produces Good, and it is always Good to do what is Right.

My lesser criticism is simply that neo-classicism is based on the factory model. The economics taught as Economics 101 is the very picture of machine production. The whole works is a machine and the people in it are treated as machines. The "demand curve" is possible because it is assumed people will consume whatever is produced; i.e., supposedly, there is always a market clearing price. Consumers are part of the glorious neo-classical (market fundamentalist) machine on a par with production workers, financiers and the non-human machinery as well. It is all put together as a Newtonian clockwork. Neo-classicists then and now are captivated by the machine, just as some people are mesmerized by the magician's swinging watch. Of course, all of that was before Chaplin's Modern Times and Kubrik's A Clockwork Orange.

I don't have a quarrel with neo-classicism, properly applied. It does work when the underlying facts justify it. For example, neo-classical analysis is very good at explaining the costs involved in running a totally automated production line. It works for robots. And, it is very good at explaining "market behavior" when human market participants are brainwashed into behaving as expected; i.e., when people behave as trained lab rats. The trouble with neo-classical economics begins when the factory breaks down, or when someone has an original thought. Capitalism stops working as soon as people refuse to produce or buy the shoddy, defective and poisonous products they are induced to see as valuable by costly "marketing." People who support market fundamentalism are under the illusion that they make their own choices, when they are actually guided to their decisions. Acting as a truly free agent dooms "free" markets, because industrial Capitalism cannot tolerate freedom. Mass markets require the stereotypical people who compose the "masses."

The simple analogy is this: Just as the rigid, mechanical Victorian World ended in the discovery of Relativity and Quantum Mechanics, so the rigid and mechanical neo-classical economics ends with Lord Keynes' invention of macro-economics and the 1960s' re-discovery of human freedom. We are not machines, and the world is not a mechanism. What sort of economy we have, and how we prefer to behave, are, within very broad limits, matters of choice. We don't have to worship at the Temple of Classical Economics, or pay tithes to its High Priests.

Marginal Pricing

This brings me to the major criticism, a flaw in the supply and demand model even if the world is some sort of giant factory. Neo-classical models assume that prices are set at the margin, which is a required premise in the evaluation of neo-classical marginal utility. The premise involved in marginal utility is that the cost of the next item produced is a function of decreasing supplies and decreasing willingness to pay the finished product price. The possibility that marginal utility might increase with increasing production, or be a complex (possibly multi-dimensional) variable of market price, or even have nothing to do with market prices, is not considered in classical theories. There is just one way things work in production, and that is like Adam Smith's pin factory, which is a Newtonian clockwork. There is just one way things work in the consumer market, and that is like a person shopping for a discretionary good.

As I have railed many times, neo-classical economics fails to consider the costs of collateral damage to people or "externalities" such as the environment. If a company can make money selling radium to human buyers seeking "fashion," it does not matter that the product is poisonous and causes cancer. If a company can make money by dumping PVCs or other toxic wastes in the ground, or the taxpayers are saved a buck or two by the military pumping toxic liquids into the water table, these are unaccountable "externalities." When economists make adjustments to their incomplete theories, they often do so by introducing the costs of regulation or lawsuits as "costs of doing business" (overhead). That this is a serious deficiency in neo-classical theory becomes obvious when it is discovered that almost all natural resources, the environment generally, and human consequences are all "externalities." Adherents of the neo-classical theory are transfixed by products and the workings of machines, not the well-being of their fellow human beings or the planet that nurtures them. In this, they are like teenage boys glued to their video games.

Since I am writing this while Hurricane Katrina strikes New Orleans and other places on the Gulf Coast, causing many deaths and injuries, and billions in damages, I note this storm may be another "externality." Human use of fossil fuels and other organic chemicals has increased the concentration of greenhouse gases in the atmosphere. Greenhouse gases are so called because, as a matter of scientific fact, they retain insolation, resulting in a heating of the air. When Earth's atmosphere heats up, it moves about more aggressively, which disrupts historical circulation patterns. The net effect is to warm up the polar regions, which act as a heat sink that stabilizes the temperate zone climate. When the polar ice melts off, there is no more buffering of the heat, and the entire planet warms up dramatically. We are now approaching this last stage. The connection with Hurricane Katrina is this: as a result of "global warming," Atlantic hurricanes are expected to become more fierce and random in their paths. Hurricane Katrina is probably an example of such storms in a changed climate. In neo-classical economics, the hurricane and climate change are unaccountable "externalities." (To my way of thinking, that in itself is enough to discredit the whole subject; but, who am I?)

One of the key methods involved in neo-classical economists is the setting of price. According to those dismal practitioners, everything has its price, even human life. That assumption leads to Actuary Tables and the relative values of whole lives, arms, legs and other body parts. Again, it is assumed that one life is interchangeable with another, an assumption that makes it possible to set values for insurance purposes. Although that assumption does not represent how almost everyone feels (not even Actuaries, excepting suicides), it is still used without question. In doing so, the neo-classicists avoid the subjective reality of our existence, supposedly in favor of the cold, hard facts. But that supposed cold objectivity is actually cultural conditioned. The value of life and limb varies from culture to culture, depending on a myriad of imponderable factors. The valuations leading economists make of our lives, our business doings and our property is entirely, subjectively theirs.

This is not unexpected, as a crucial basis of neo-classical theory is that value is found in the eye of the beholder. In turn, that is a consequence of Enlightenment theories of sensation and value, which are partly owing to David Hume and like minded philosophers. Because Hume made the distinction between 'is' and 'ought', he needed some foundation for the 'oughts.' The Enlightenment empiricists felt reasonably certain about founding "is" in sensation, which seemed to have a mechanical explanation. The sensations of light, heat, taste, etc could be connected to the material world by material means, so our bodies and the world were all of a piece. The difficulty arose that, in separating 'ought' from 'is,' ethical judgements, and judgements of value generally, had no obvious grounding in the material world, but the empiricists did not want to attribute human judgements to the soul or other non-material sources. So, Hume and others invented the "moral" or "aesthetic" sense. Problem solved: there was some sort of innate ability to detect value in the objects of the world. This built-in sense made it possible to ascribe truth, beauty and good to things, and construct the moral order of the Universe. At the time of their inventions, the empiricists did not drift too far from Orthodoxy, because in the Eighteenth Century, and even in the Nineteenth Century, apostasy was still dangerous to one's freedom, health and life. Heretics weren't just shunned; they were imprisoned, tortured and even executed. Thus, empirical theories allowed of interpretations that would be acceptable (if somewhat suspect) to various national, religious authorities. Because of its foundation on the empiricists' value theory, classical economics is based on the notion that economic players have some sort of innate sense of value. That sense, together with the "invisible hand" and other miraculous workings, allowed a smooth correlation of economic matters with religious and cultural sacred cows. Because neo-classical economics relies on such mysteries, its practitioners often act like high priests of an arcane religion.

The curious effect of the innate sensation theory of value is that it makes each person's values relatively absolute; i.e., there is no simple way to challenge whatever value someone places on something. Thus, if I happen to be an Archie Bunker, there is no reasonable way to cure my prejudices. The further consequence of such a theory is that it sets the measure of marginal utility of products by auction price. The product is worth whatever the people who bid for it think is worth; it is their absolute, yet subjective, opinion which sets value. Although not all instances of products are on sale at once, the values of products now on sale are just what they are assessed to be. This is a familiar, but actually difficult point. Again, the value of the products on sale is assigned by whoever makes the assessment at the time, without regard to all of the other products which have been sold or might be sold or their provenance or social utility. This comes down to the very familiar procedure by which the price is set by the last accepted offer for it. This is a very ancient and natural procedure called "bargaining" or "bartering." It apparently worked well for our ancient ancestors. So, in explaining valuations and economic transactions as bargaining, the empiricists and Adam Smith were not doing something out of the ordinary.

In the auction system of pricing, the value of everything considered comparable to the item being bid is set by the latest bid or sale. Thus, if one share of AUTOBLOG is worth $100, all shares of AUTOBLOG are worth as much. Those who paid $3 for AUTOBLOG shares yesterday are elevated by this decision, as now their equity is increased to $100 per share. Similarly, the reverse is true: today's buyers at $100 can be pauperized when the stock falls back to yesterday's $3 valuation. In this system of valuation, it does not matter what the so-called "book value" of the property may be, nor are "good works" or importance in the overall economy or social order relevant. The effect of this system of valuation is that anyone owning AUTOBLOG can value it at whatever the recent price is. So, today, it's worth $3 and tomorrow $100. One's wealth or lack of it is shown on the balance sheet including AUTOBLOG.. Dr Greenspan talks about balance sheets all the time, and obviously considers people well off when their balance sheets reflect an increasing, positive net worth. This makes people who own things that rise in value feel good. The money system rewards them for rising balance sheet values by giving permission to own more things. So, the rich get richer.

I believe this method of valuation is a fatal flaw in the Euro-American capitalist system, because it creates unearned wealth which can be turned into unwarranted demands on the system. Since there is no public evaluation or decision of the value, a few private parties can make it go up or down at will. Just a few trades in shares of AUTOBLOG can make all sorts of people millionaires or paupers. (It's a rare day when even 1% of a company's shares are traded.) If the shareholders are newly minted millionaires, their balance sheets earn them a credit rating which, in turn, allows them privileges such as buying houses, cars and other things. Paupers are unable to implement such choices. Having a high net worth not only earns more net worth, but, more importantly, awards the property owner directive power over the economy. Thus, a relatively small proportion of the population can direct the output of major portions of the economy. For example, a relatively small number of buyers can redirect major portions of automobile production into highly profitable SUVs and luxury cars. "Paper" amounts on balance sheets are transferred to automobile manufacturers as income. Of course, the purchased vehicle has an asset value, so it reappears on the buyer's balance sheet. The net effect is the actual creation of fungible money on the manufacturer's books as a side effect of the exchange of assets on one owner's balance sheets. In this example, it doesn't matter that 100 other people want inexpensive, fuel efficient cars. It only matters that the credit worthy buyer purchases the vehicle he or she wants. Magnified, the result is the upper class (by income) has an exponentially greater control over what work is done, because they control what products are demanded.

So, it should be easy to see that valuing things by the last bidder or sale has pitfalls. The simple barter system worked well enough for the ancients because it was implemented as small, unconnected transactions. When an ancient farmer exchanged his wheat for a knife, that choice did not influence the course of production for a whole economy - even if many other farmers made the same decision. In Adam Smith and neo-classical economics, it is (once again) assumed that people still make isolated, independent choices. But the few examples I've made should show that premise is false. In the modern, interconnected economy, there are very few isolated choices. Those lucky enough to own things desired by others are made "more wealthy" by that desire. That increased wealth is not without consequence: it gives its possessor more power over others by directing what will be produced for everyone else. That is contrary to what neo-classical theory predicts.

Neo-classical assumptions about setting value don't "scale up." The assumed bottom layer is simply a personal valuation: 'this is worth it.' If, for whatever reason, one's compatriots walk away from that judgement, then 'this is worthless.' Somehow, by an integration of affirmations and denials of value, the putative value of the thing is determined. That's how it is done in Newtonian Mechanics. The difficulty is that, in the real world, the result is not a simple linear integration. For example, it could be a recursive function; i.e., a function that evolves based on its prior state. Those who remember Gödel, Escher, Bach should recall many examples of recursive functions, which are related to Mandelbrot's fractals. But recursion and fractals are not the only possible forms by which societal decisions "crystallize." The only thing we know for sure is that human decisions are the results of complex interactions, unless people are subjected to forcible, external controls. Perversely, those committed to neo-classical economics usually try to make their predictions come true by external controls called "advertising" and "market research." In using that approach, they rely on the further fact that humans can be programmed. When people are left to their own devices (pull the plug on that TV!) the decisions are not as expected.

The original capitalists thought the market system would bring about the products people wanted. Neo-classical economics works, as long as you force people into its framework. Even then, it does not work the way its founders suggested. Today the classical theory is just a mechanism by which the rich and powerful manipulate everyone else.

The problem lies in the basic capitalist tool kit. Just as Newtonian Mechanics only works locally, but is superceded by Relativity at very large scales, and by Quantum Mechanics in very small scales, Adam Smith's assumptions have a limited range of application. Recent industrialized and automated "mass production" societies don't work the same way as their antecedent rural, agricultural societies. These days, very few people are born outside of a hospital. Today's farmers would fail if they did not have the benefit of college education, University agricultural "agents," and massive government intervention and support. Despite the myth of the family farmer and free markets, agriculture everywhere is a highly regulated and subsidized industry. There are still a few people capable of subsistence farming, but most of them are quickly forced into retirement by disease, injury and premature old age. Henry Ford invented the idea that the worker had to make enough to buy the product, which was never part of the neo-classical conception. In the final analysis, capitalism is about capitalists, not working people (labor). The Twentieth Century goal of a humane society - the Welfare State - is something new, something not implicit in the original conception.

As in the physical sciences, it is appropriate to treat neo-classical economics as a lesson in the core curriculum. Everyone learns the classical physics, because it is easy. The really hard stuff is reserved for those making it to the second and third years. In the same way, we have Econ 101, but there is economic knowledge beyond that.

My suggestion in this paper is that the auction (market) price mechanism is one of those antique concepts which has limited use in the modern world. I believe it causes havoc in today's larger, interconnected societies because it incorrectly assigns value based on a small and even random sample. Auction pricing denies any meaning to "book value", "fundamental analysis," and other attempts to assign value to property. In the auction system, the only thing that counts - by definition - is the price. This immediately leads to various forms of speculation, and schemes for "gaming the system," because the only thing that counts is the transaction price. That this measure of value is not stable is easily seen when we consider the Bubbles and Crashes that have occurred during the last century.

We need to have a system that considers social utility in the price. Regardless of the wiggles of the stock chart, certain things need to be done to keep people alive and well. Those activities need to be valued in such a way that they continue to be done. In the short run, it should not matter whether Joe Blow invents the radio, TV or computer: food, clothing, housing, education and medical care should go on. When the new inventions improve the process of making food, clothing, etc, the changes should not devalue those services (which is what happens now). All such examples point to the need for a major change in the way we determine prices. "Social" utility means that price has a public component; it is not merely the opinion of certain privileged individuals. The setting of value by private entities (i.e., non-governmental agents) implicit in neo-classical economics was fine for pre-industrial, horse-and-buggy societies, but it is a dangerous antique when let loose on the freeway.