We Urgently Need To Revert To Classical Economics
Where the problem lay in the current economic system......
By Martin Wolf. Chief economic writer of the Financial Times.
Why were resources expunged from neo-classical economics?
Something strange happened to economics about a century ago. In moving from classical to neo-classical economics — the dominant academic school today — economists expunged land — or natural resources. Neo-classical value theory — based on marginalism and subjective valuation — still makes a great deal of sense. Expunging natural resources from the way economists think about the world does not.
In classical economics, land, labour and capital were the three factors of production. With neo-classical economics, the standard production function had just two factors of production: capital and labour. Land — by which we mean the totality of natural resources — was then incorporated into capital.
All thinking about the world involves a degree of abstraction. Economics has taken this principle further than any other social science. This is a fruitful intellectual procedure. But it is also risky. The necessary process of abstraction may end up leaving essential aspects of the world out of the analysis. That can be intellectually crippling. I believe that that is exactly what has happened, in this case.
The idea that land and capital are the same thing is evidently ludicrous. It requires us to believe that the economic machine is self-sustaining — a sort of perpetual motion machine. Capital is the product of savings and investment. It is the result of human frugality and the invention required to imagine and create new capital goods. Labour is also — and in today’s circumstances, increasingly — a form of capital. Parents, governments and individual people invest in their own skills, so making themselves more productive. Yet there would be no economy — indeed no humanity — without a constant inflow of natural resources into the system: what lies above our heads (the sun and the atmosphere), what lies close to us (the soil, the seas and location itself) and what lies beneath us (fossil fuels, metals and minerals and heat). Humanity does not make these things; it exploits them. Some of these resources are also appropriable and so a source of unearned personal wealth.
Why did this compelling distinction disappear from economics? After all, no economist can believe that the economic system will move without a constant infusion of external resources.
One reason was that the classical world view implies diminishing returns. Since the supply of land was fixed, it would become ever scarcer. Rents — the price of resource scarcity — would rise, profits would fall and growth slow. But the economy did not show signs of diminishing returns. Technical progress seemed to offset any tendency towards diminishing returns. So assuming that land, like capital, could be effectively expanded, without limit, via land-augmenting technical progress, seemed to be the right thing to do.
Another reason may have been political. Henry George argued that resource rents are not a reward for the efforts of the owners, but the fruit of the efforts of others. It would be both just and efficient to socialise rents, he argued, and then use the proceeds to finance the infrastructure that makes resources valuable. But the powerful owners of natural resources wished to protect their unearned gains. In practice, therefore, the tax burden fell on labour and capital. Economics, one might argue, was pushed into supporting this way of organising economic life.
Yet it would seem to me that this way of thinking by economists is no longer sensible, if it ever was. Land must again be treated as separate from labour and capital.
First, resource scarcity is an increasingly pressing issue. It shows up in concerns over pollution (including global warming), in the discussion of “peak oil” and so forth. The idea that diminishing returns will become a more significant factor in the next century than in the past two seems to me to be compelling, now that modern economic growth has spread across the globe. So we need to return to economic models that incorporate resources, as a matter of course.
Second, in a globalised economy, taxing labour and capital will become increasingly difficult. That leaves land. The Australian government is right to want to extract the full rental value of its mineral resources for the benefit of the Australian people. Similarly, the people of the UK should wish to extract the rental value of London for their own use. The benefits of infrastructure investments that make London more productive would automatically be recouped if land rents were heavily taxed. Meanwhile, the taxation of capital and land could be reduced.
I can see the objection that natural resources are necessary for the operation of capital and labour. Thus, the distinction between land, labour and capital is hard to draw. I agree with this. But there are two responses: first, from the point of view of economics, resource scarcity may mean diminishing returns, which are economically important; second, some natural resources are not appropriable and can be treated as free (sunlight, for example), but others are indeed appropriable.
Thus, for both economic and political reasons, we should put natural resources into the heart of economics, thereby remedying a neoclassical mistake.
The old fallacies are skillfully debunked in this long exchange:
http://blogs.ft.com/martin-wolf-exch...mics/#comments
Martin Wolf concludes.........
The essential point is quite simple: the value of resources is created by the economic activity of other factors of production. The owners of these resources can become hugely wealthy and are often untaxed on that increase in wealth: the Duke of Westminster is the richest Englishman simply because he owns a large amount of land in a valuable part of London. So why should he have command over the labour of so many other people?
That wealth is, in the strictest sense, unearned. If that rise in wealth were taxed away, other taxes - those on labour, capital and entrepreneurship - could fall. This would be both efficient (because taxes on rent do not create distortions, as Ricardo showed) and also just, because the wealth was unearned. Now, surprisingly, the UK allows foreign landowners to enjoy the increase in value created by the British economy, entirely tax-free. This is utterly crazy.
Let me add four other points.
First, throughout history, the main source of wealth was land-ownership. The parasitic landowner became wealthy on the efforts of others - peasants, tenants and even developers. Sometimes the parasite was also a farmer or developer, but that does not change the fact that these are two distinct economic roles. The parasite built fine castles and palaces and often sponsored music and culture. But he was still a parasite. The beauty of capitalism is that many of the wealthiest are no longer parasites. This is good. But many of the wealthy still are parasites. Moreover, now everybody wants to get rich by being a mini-landowner. That is a huge diversion of effort.
Second, the financial system's ills are the result of unchecked credit-creation. Yes. But unchecked credit-creation would be impossible without collateral. Land is always the principal form of collateral (buildings are a depreciating asset). That is why financial bubbles that do not create credit booms (like the dotcom bubble) are economically benign, while property bubbles are potentially catastrophic. When the value of collateral collapses, the financial system implodes.
Third, there is really nothing new about this understanding of the role of resource rents. They were central to the classical system, from which modern economics, in its various forms, derives. Ricardo's analysis of rent remains intellectually impeccable.
Finally, as Herman Daly has noted (http://steadystate...zing-henry-george/), today economically valuable resources are much more than just land (and what lies below it). They include all the services of the biosphere - those that are appropriated, those that are appropriable and those that are non-appropriable. If we do not think seriously and intelligently about how to price resources, we are likely to go seriously adrift, perhaps even into disaster. Here land is the least of our problems - it is appropriable and, by and large, appropriated. So, at least, the price mechanism works, even though the distribution of the gain is grossly unjust. But, in other cases, no appropriation is possible, or at least it is not easy. Nobody can appropriate the atmosphere. It is nigh on impossible to appropriate the oceans. How do you own species diversity? These are serious challenges.
So, I conclude where I started: resources matter. It was a great mistake to exclude them from the canonical neo-classical model. It is also a great mistake not to tax their owners to the hilt.
Vested Interests Rigged The Economy
The Queen Could not be Told the Truth
When the Queen of England visited the London School of Economics. She asked a simple question about the looming economic disaster,
"why did no one notice it coming?".
Professor Garicano replied,
"at every stage everyone was relying on someone else, and all thought they were doing the right thing".
As modern economists use a collection of mangled economics the Queen could not be told the truth.
Economists 100 Years Ago Colluded to Distort Economics
A century ago a group of influential economists: John Bates Clark, Frank Knight, Francis Walker, Edward Seligan and Richard Ely, colluded to manipulate the building blocks of classical economics. They had an ideological agenda. The future they shaped is our reality. Their mission was clear to protect the vital interests of the privileged few. To so they had to conceal the unique qualities of the classical factors of production - LAND.
A century of economic disasters followed that literally messed with our lives. Economics has been a tool for contorting our collective consciousness. The current economic crisis as an example to the pathetic state to which economics has been reduced.
Modern Economists are Confused
We handsomely reward economists to fine tune to the economy to keep it stable. When boom turns to bust they escape into mysticism. They claim,
"occasional slow downs are natural and necessary features of a market economy".
The people we trust to keep the economy on an even keel have no idea what makes an economy explode. Take the central bankers, they pontificated, moving interest rates up and and manipulating the money supply. They didn't know what they were doing - it was all an illusion.
The problem lies in some of the theories invented by encomists. They do not reflect the real world. They are fictions invented to explain an imaginary market economy. When the economy overheats the imaginary equations turn out to be useless.
Economists Admit Their Economic Models Do Not Work
The Daddy of all central bankers was Alan Greenspan, of the US Federal Reserve. He said,
"the models do not forecast recession because the parameters are dominated by what happens in normal times when the economy is growing".
As the economy crumbled, He said to the US congress,
"I discovered a flaw in the model which I perceived as a critical function structure which defines how the world works, I was shocked".
Greenspan's victims are more than shocked, they are traumatised losing their homes and jobs.
In failing to raise the warning flags, Greenspan was not alone, economists at the Bank of England also failed to forecast the end of the business cycle. They confessed their economic models break down when the going gets tough. Rachel Lomax, deputy governor of the Bank of England confessed,
"When it comes to quantifying the changes in credit conditions, our workhorse economic models still cannot help us very much".
If you were caught by surprise when the bottom fell out of the credit market, don't worry, you were in good company. Leading economist at places like the LSE were also shocked. Professor Sir Charles Woodhart, served on the Bank of England monetary policy committee, he now admits that standard forecast economic models are
"effectively pretty useless".
Here is an example of the nonsense that can be produced by economic theory. According to the British governments Property Valuation office in Jan 2008, land values will continue to rise until 2013. Six months later the economy had broken down. The graph has been erased from their web site.
Land Speculators Are the Biggest Gainers
Who gains from this intellectual mess? One groups of people reap spectacular rewards, property developers, land speculators all reap windfall gains from one asset that sustains us all, LAND.
In the good times when people go mad buying and selling properties, we lionise these developers. Yet all they are doing is cashing in the on the land values others create. Take the case of a cluster of flats adjacent to a prime brownfields site. Their presence gives value to the adjacent site, yet the thousands of residents of the flats will not share in the increased values they help create.
Banks Fuelled The Property/Land Bubble
Bankers around the world played their part in the economic crisis pumping up credit to fuel the property bubble. As land values rose bankers even created more money. This was a self inflated bubble of hot air. It had to burst.
Economists Who Know The Answers Are Supressed
For the past century economist have messed with our minds. All is not lost. A few economists have been stewards of the precious knowledge of how the economy works. The Nobel prize winning economist Bill Vickry and the California professor, Mason Gaffney. All voices of reason that have been suppressed.
We Need To Force Through ChangeTo Eliminate Vested Interests
With all the global crisis's converging, mass unemployment, poverty, terrorism. It is time to make up our minds and stop playing the game that was rigged 100 years ago. If we do not challenge the vested interests that exploit people, all of us, the environment and future generations will pay the ultimate price.
We have to oblige our elected leaders to deal with the realities on the ground. In the end it is up to everyone to assume personal responsibility and restore common sense in the way we govern society.