A Response to Kanbur/Stiglitz: Economics is a Mess, and Economists Need to Fix it. Fast.

This post was basically written to be posted over at Naked Capitalism. It was written as a response to this post: http://www.nakedcapitalism.com/2015/08/kanburstiglitz-rent-seeking-as-a-major-driver-of-wealth-and-income-inequality.html

EDIT(8/20/2015):  Well, Naked Capitalism chose not to publish this.  Perhaps it is a bit frenetic.  I did crank it out in a few hours. As may be.

One possible issue is I did not address 'rent seeking,'  per se. My view on rent seeking is that it is up to the regulators of an economy to minimize and distribute it, and up to economists to provide the best theory for doing so.  Since basically everyone tries to  do it all the time, to address it as original cause would seem not to be a properly economic issue.  However, if the problem is some institutional structure which permits some small slice of society to damage the rest of society with their rent seeking, then that institutional structure is what  you want to address.

Anyway, if you disagree with this post, please comment.  If you agree, feel free to comment, also.  And then you might want to help spread the word. END EDIT.

A Response to Kanbur/Stiglitz:  Economics is a Mess, and Economists Need to Fix it.  Fast.

Recently, Yves crossposted (from VOXEU) an analysis by professors Ravi Kanbur and Joseph Stiglitz.  (Also posted by Mark Thoma at http://economistsview.typepad.com/economistsview/  )This analysis raises the issue that currently fashionable theories in economics may not be able to adequately explain our current, unequal, economy.  While their analysis has value, and admits to serious problems in the study of economics as it is currently understood, the post does not go nearly far enough in acknowledging or addressing the actual problems which may be found in the foundations of the field of economics,. 

As can be shown, these problems rest with some of the fundamental assumptions underlying the practice of economics, and until these errors are addressed, economics will continue to only poorly represent the reality it seeks to describe.

First, regarding the particular issues raised by Profs. Kanbur and Stiglitz.  In the concluding remarks to their post, they propose the following changes to the analysis of the problem of inequality.  They propose these changes as necessary to gain an adequate understanding of the problem: 

“Concluding Remarks

Thus, the new stylised facts of our era demand new theories of income distribution.

• First, we need to break away from competitive marginal productivity theories of factor returns and model mechanisms which generate rents with consequences for wealth inequality.

This will entail a greater focus on the ‘rules of the game.’ (Stiglitz et al 2015).

• Second, we need to focus on the interaction between income from physical and financial capital and income from human capital in determining snapshot inequality, but also in determining the intergenerational transmission of inequality.
• Third, we need to further develop normative theories of equity which can address mechanisms of inequality transmission from generation to generation.”

To be fair, the first item is actually a pretty deep cut.  ‘Marginal productivity theories’ are fundamental, some of their basics taught to budding freshmen in Econ101. For any economist to call these into question is an act, first of all, of intellectual courage. 

However, I think the problem with this formulation runs at once deeper, but is also more shallow, than the real issue.  On the shallow side, models are what economists construct to gain an understanding of a very complex reality.  If in some way, the behavior of the model mirrors the behavior of reality, the model is usually considered a success.  Models can be simple, and based on a few simple assumptions, or like the Kaldor-Kuznets model Profs. Kandur and Stiglitz discuss, more complicated, and based not on just simple assumptions, but some previous body of theory developed from and based on those assumptions.  So questioning such a sophisticated model is only an incidental attack on its underlying assumptions.  And replacing such a model, then, with one based on equally sophisticated theory, does not necessarily address the underlying problem with the assumptions.  And here, Kandur and Stiglitz  seem to be proposing we essentially start with model mechanisms which must ‘generate rents.’  This seems to beg the question, and so such a model will likely be basically useless. 

And on the deep side, are the assumptions underlying ‘marginal productivity theories’ the correct ones to attack?  I am not so proficient at economics that I can determine whether the assumptions underlying ‘marginal productivity theories’ are above reproach.  In my understanding of the theories, however, they seem pretty useful, and generally so.

So I can instead offer alternative assumptions, different from the assumptions I believe economists make, calling them into question. I believe the economics profession should, in any case, examine them.

Now. for item two, however, I think Prof. Stiglitz makes a wrong cut.  He lumps physical and financial capital together, when they are not at all the same thing, and the difference is especially glaring for this problem.  In particular, financial capital feeds off physical capital.   Prof Stiglitz then lumps all human capital together, when the relevant distinction is between labor, in particular labor closely tied to physical production, and management, in particular those who manage financial capital.  Thus the appropriate associations are between physical capital and labor, and between financial capital and (upper) management: The one exploits the other, and indeed, that is how we can define them.    So he puts the lions and the lambs in the same pen.  Twice.

But, let me add that the assertion financial capital and upper management exploit labor and physical capital may be unfair.  The necessary counter claim would be that the benefits to labor and physical capital of the activities of management and financial capital outweigh the costs to labor and physical capital of those activities.  This claim may, in fact, be true.  The claim would seem, however, to be contradicted by the evidence of the combination of increasing inequality, and the decline in the investment in and even maintenance of, society’s real capital. These processes do suggest that ‘exploit’ is indeed the proper word.

In item number three, I believe Prof Stiglitz implies that current normative theories of equity are basically correct, but “further” theories need to be developed, and presumably developed from those basically ‘correct’ theories. 

One of the fundamental and essential assumptions underlying current theories of equity, however, is the standard, textbook definition of money. If this definition of money is in error, then so is our understanding of equity.  So is our understanding of asset. So is our understanding of the nature of investment.  And so would our understanding of the flows and distributions of assets and their distributions. We could not claim to understand either the state of an economy, nor its dynamics.  In all these things we would be no more than part right, and certainly also quite mistaken. So. 

Conventional economics must examine some of its fundamental assumptions.  Here are three corrected assumptions for economists to look at. They need not agree with my assumptions.  But, as Yves said to my earlier post, they need at least to refute them.   As a fourth item, I also bring to attention statistical mechanics.  This is a field whose potential contributions I believe economists fail to appreciate.

1)        The textbook definition of money, which I assume is still relevant to the study     of economics, is wrong:  Money is only incidentally a measure or a store of value.  It is actually a measure and store of *demand* on (things of real) value.  Because money is merely demand, it cannot reliably distinguish between productive assets, and ‘assets’ which are in fact a drain on production and maintenance of real wealth in an economy.  Money, for instance, cannot distinguish between the value of a high school, and the value of a yacht.  In fact, money, especially if badly distributed in an economy, favors the production of yachts over high schools, and in general, the consumption of resources over their production. I argue this point in greater detail at: http://www.nakedcapitalism.com/2015/06/the-standard-definition-of-money-is-in-error.html

2)        While the costs of factors of production are additive, the combination of factors in production is multiplicative.  Labor and capital multiply to create production.  Consider, for starters, how much is *added* to the value of the freight of an empty truck going across country.  And in general, where the cost of an activity exceeds its benefit, it is because the multiplicative factor of that activity is less than one. For example, in the analysis of sectors, finance is multiplicative, as is government.  For another example, academia, and in particular the study of economics itself, is multiplicative. To say that economists add to the value of things produced in an economy is absurd. Economists produce nothing of substance: Nothing that anybody can eat;  Nothing that will heat anybody’s home.  What they do produce, or are supposed to produce, is understanding. This understanding offered by economists can multiply the productive capacity of an economy. Policy adapted from correct theory can increase the productive efficiency and resiliency of an economy.   Efficiency is a multiplicative factor. This factor can be greater than one for sound policy.  Or that productive efficiency can be reduced, the multiplier become less than one, when policy is based on unsound theory.

3)        The motives of capitalists are not the same as the motives of society as a whole.  Therefore, there is no guarantee that the activities of capitalists advance the interests of society.  Indeed, where their motives conflict, where, for example, there is opportunity for capitalists to externalize the costs of their activities, there is every reason to suppose otherwise. 

4)        The study of statistical mechanics is a well developed branch of physics, and one that a few physicists, at least, have been trying to apply to economics.  For statistical mechanics to have application to large systems of ‘particles,’ all that is required is some form of interaction between the particles. One implication of the approach is that there are what might be called ‘natural’ distributions of wealth an income.  Resources must be consumed to maintain distributions of wealth and income which are different from these ‘natural’ distributions.  And indeed, the greater the deviations of these ‘unnatural’ distributions from the natural ones, the more resources which must be consumed merely to maintain them.   There are problems with dimensionality to be worked out, and I have not been following the literature.  However, I can say that I have not heard much about this approach from economists.  I do not access the formal literature all that much, but from the economics blogs I frequent, I have heard nothing.   http://arxiv.org/pdf/cond-mat/0211175v1.pdf

       “Statistical Mechanics of Money, Income, and Wealth: A Short Survey,” from       2002 might be a start for the interested economist.    

Kanbur and Stiglitz are deserving of great respect, They have labored long and hard and produced important results in the difficult and, what also should be, the immensely valuable field of economics.  But, if the assumptions those results are based on are in error, then much of the effort that they and their colleagues have expended have been wasted. And the same can be said of any future investment they, and our society, make, if any errors are not corrected.  Worse, much of those efforts may even have been counterproductive, and this may continue.

To many outside observers, the study of economics seems incoherent. Is it? In many cases, diametrically opposed descriptions and prescriptions can each find support from one or another school of economics. If the study of economics is incoherent, this raises the questions: Is the study of economics incoherent because it is politicized? Or is it politicized because it is incoherent?  If economics is incoherent because it is politicized, then it cannot qualify as a science: It is not the study of, or the theory of, any objective phenomenon. It is, and can be, no more than one or another’s propaganda. 

If instead economics is merely incoherent in the understanding of economists, economics as a science need not be incoherent in principle. For coherent theory to be developed, consistent assumptions need first be discovered.  This failure of understanding then, a failure which is exploited by politicians, is because the assumptions actually used by economists to make and base their theories on cannot be consistent. From inconsistent assumptions, mutually contradictory conclusions can be drawn.  If contradictory conclusions can be drawn, we should not be surprised that the various players should choose from economics those conclusions which favor their own interests, and those economists, who espouse those conclusions. Neither should we be surprised if those players also deny the conclusions which stand in opposition to those interests. After all, they have refutations, and people to argue them.  And so we should also not be surprised if many of the pronouncements of economists are ignored.

Incoherency also implies that any conclusions economics reaches will fail, at least in part, to correspond to reality, where economics is so understood.  This does not necessarily mean here that economics will totally fail to represent reality.  Indeed, microeconomics provides much excellent application. But the true definition of money is not important in microeconomics.  In macroeconomics, however, the definition of money may be very important.  I claim that money, and its flows, impose many significant forces on an economy in the large, with the consequence of many stresses and distortions in that economy.  In this I do not think I am alone. So if the definition of money is in error, then so long as it is in error, explanations for these distortions, if even they are noticed and recognized, will remain mysterious.  The best theories will be no more than ad hoc rationalizations.  Like the Ptolemaic Cosmology, these theories will be bereft of any true insight.  

It is the implicit opinion of some policy makers on the Right that society has no genuine need for economists, or their dubious ‘economics.’  Their claim is that the free markets of unfettered capitalists create the optimum economy, and the optimum society.  To them, the only use for economists is to enable such capitalists to more efficiently exploit these markets, and so enhance their profits. Nowhere for them is there any other role for economists. There is no point to economic analysis, because there is no point to economic governance. To them, there can be no better economy.  There can be no better society.

One final word:

Today’s academic money-centric economics is to very large degree woefully unequipped to handle the analysis of the demands of an increasing population on a diminishing resource base. Most seem to be in denial, their activities increasingly irrelevant to our collective future. What ever else he, or she, may think of this post, every economist, every reader, needs to look at: http://www.overshootday.org/  and the links it points to.

Their analysis concludes that humanity is using the earth’s resources at a rate it takes 1.6 earths to replenish. The other way they put it, for the year up to August 13, humanity consumed the amount of resources it would take the earth one entire year to replace. Simply, we are consuming our children’s future today, and at an ever accelerating rate.

There is a need for a correct understanding of economics. There is a need for economists to clean their house.

It is the case that while we may never run out of money, we may run out of the things that money will buy.  However, if the standard definition of money is correct, we may indeed be fortunate. According to the standard definition of money, $10 of money has the same value as $10 of food.  So if we run out of food, we may yet be able to eat the money.

A Second Reason Libertarian Societies must Fail

In the previous post, we argued that a mechanism for the redistribution of demand was required to maintain a society. In a libertarian society, there can be no such mechanism. In consequence, in a libertarian society the market for production is progressively destroyed, and with the market the entire economy.

There is also a more direct reason libertarian societies fail: Libertarian societies provide no adequate mechanism for protecting your neighbor from  the aggression of others.  There must be a mechanism, because without such a mechanism, there is inadequate motive for you, or anyone else, to help your neighbor resist the bully.

It is in the concentrated interest of the bully to oppress your neighbor.  The bully may profit greatly if he succeeds.  The benefits to the bully will be greater than the cost.  But you, and everyone else, only have a diffuse interest in helping your neighbor resist the bully.  The cost to you to help your neighbor is concentrated, and may be far greater than the benefit to you.  Further, if mutual aid is agreed to, but such protection is voluntary, it is in your interest, and the interest of others who might be expected to contribute, to contribute as little as possible to the protection of your neighbor. Which would likely be nothing.  This is an instance of the free rider problem: If anyone can ride for free, everyone will ride for free, because only a fool, (or a saint, perhaps,) would pay for what is offered for free.

So the consequence is that in the absence of government, and police, and regulation, the bully, the large organization, the wealthy, will dominate and oppress your neighbor, and after your neighbor, you. A government diffuses the cost for the protection of your neighbor across the whole society. In the libertarian state, some are more equal than others, and the more equal shall devour the liberties of the less equal, because the only thing to stop them is: principle.  That is, in libertarianism, the only mechanism to stop the powerful from effectively enslaving the weak is the moral disposition of those same powerful interests.

From the point of view of Widerquist's thesis, there is only the pronouncement of platitudes and the benevolence of the powerful to prevent the establishment of absolute monarchy by force of violence. There is no real reason for the prospective despot to wait on 'legitimate' means.  

Why there are no Right Libertarian Societies

Why there are no Right Libertarian Societies 

Despite the attractiveness, to some, of libertarian prescriptions for creating a ‘better’ and ‘freer’ society, there is a notable absence of any examples of states run according to libertarian principles in the record of history.  The reason is that libertarian societies, as a matter of definition, lack an institution, ( a government, basically) capable of redistributing demand.  They thus are incapable of dealing with the producer-consumer problem, (which I describe below,) and so fail.

One of the problems in dealing with libertarian economics is the protean nature of the libertarian state, which, in the hands of libertarians, changes according to the criticism leveled against it.  That is, what ever the libertarian state one criticizes, it is not the state advocated by any libertarians.  

Anyway, from Karl Widerquist (who, granted, seems to be no apologist for libertarians,) “A Dilemma for Libertarians,” we have:

            “Libertarianism can be thought of in at least three ways: It is the ideology

supporting (1) maximal equal liberty understood as self-ownership or noninterference, (2)

strong, inviolable property rights without regard to the pattern of distribution of those

rights, or (3) a so-called libertarian state, which is either a government limited to

protecting property rights and self-ownership or no government at all.

 Natural rights libertarians think of their philosophy as embodying all three of these claims, believing that a commitment to maximal equal freedom entails a commitment to strong property rights, which in turn entails a commitment to a libertarian state.”

http://works.bepress.com/cgi/viewcontent.cgi?article=1005&context=widerquist

Widerquist, whose paper is well worth the read, argues that any libertarian state operating under these assumptions necessarily evolves into what is effectively an absolute monarchy.  (An aside:  A close analysis of the 11 incidents of property,  as described by Tony Honore an conveyed by Widerquist in his paper, at least strongly suggests that it is impossible to eliminate any of the functions of government.  These functions can only be redistributed.  Libertarians, then, seem to believe in appropriating all, or for the minimalist state libertarians almost all, of the functions of government to the individual.)

So we will address libertarianism as described above.  But we will show something different.  (Since here the notion of property is paramount, we will consider this an instance of right libertarianism. Here we will not address the concerns which might be raised by any of the many varieties of left libertarianism.) We show that in the libertarian ‘minimal state’ of government protecting only property rights and ‘self-ownership,’ the economy cannot maintain demand for its production, and so will collapse. (Actually, we will show something quite different from this!)

But consider then a closed model economy, consisting of two sectors: a producing sector, and a consuming sector.  We allocate to the consuming sector a quantity of money. Here we are just talking tokens of demand, as I discussed in “The Standard Definition of Money is in Error.“  With these tokens, this money, the consuming sector buys the products of the producing sector. The consuming sector must spend its money to support itself, since it produces nothing on its own, and therefore can earn no money selling what it produces. So eventually it runs out of money.  (With this model there is no provision for borrowing, or assets.  Adding these features do not change the direction of the dynamics.)  As a result, the consuming sector demand then collapses.  With the collapse of the demand of consuming sector, there is no one to buy surplus production.    Prices crash, and with that crash production, and so the economy.  Adding the possibility of borrowing, or the selling of assets by the consuming sector, does not change the direction of the process, but merely adds to its duration.

Reality is of course, more complicated. First, any economy is more properly divided into net consumers and net producers. Consumers do produce, and producers do consume, but the distinction may still be made.  Now, whenever the consuming sector of the remaining economy is driven from the economy, the remaining economy may still be so divided. That is, the remaining economy cannot produce a net surplus to its own consumption, because there is no one to buy it. No one else has any money.  Therefore, the remaining economy must reduce production to match the reduced demand. Because production is reduced, so is that part of the economy which produces.  Thus, the producing sector is less than the whole of the remaining economy, and so the other part of the remaining economy is necessarily a net consuming sector. But this new net consuming sector has only a finite amount of money, with which to buy the surplus production of what is now the producing sector.  And so the process iterates.  The actual process of collapse, then, can better be described as a continual increase in the concentration of money and wealth, as ever an ever larger portion of the economy is stripped of its demand on the ever shrinking net producing portion of the economy. 

Although we have argued from a closed economy, we can actually start from an open one.  The entire economy then is the net producer, which exports its entire surplus into the exterior. The exterior, however, necessarily starts with a finite amount of money.  And this money necessarily is eventually depleted.  And so we return to the start of the previous process, which we have already shown eventually leads to collapse.

In a more realistic monetary economy, relative profits determines who is a net consumer, and who is a net producer.  The net consumer is the one who profits from his production, and the net producer is the one who loses money from his production.

This is not intuitive.  But suppose a fixed money supply.  The producer who profits, can buy more than he produces.  That is, he can consume more than he produces.  He is a net consumer.  The producer who loses money, can only buy less than he produces.  That is, he can only consume less than he produces.  He is a net producer.  ( I would like to point out here that, under capitalism, labor, certainly at least in private industry, is a net producer. This is because, for the capitalist to make a profit, labor, in the net, must produce more than it consumes.  (Consider first a one product economy.)  Even if we include government labor, if in the net businesses make a profit after taxes, labor as a whole is still a net producer.)

 This fact inverts the conclusion:  It is the net consumer who ends up with all the money and wealth, whereas the net producer is stripped of all his money and eventually all his assets. So as promised, what we have instead shown is that it is production which is decapitalized, and which the economy fails to maintain, and that is the cause of the economy failing. 

Labor, of course, is not the only net producer.

In the libertarian economy, there is no mechanism to redistribute demand, as is required to maintain production. Voluntary redistribution of demand from the net consumers to the net producers cannot work.  The set of all producers represents a commons, and any consumer who restrained his consumption would be exploited by other consumers.  And any compulsive mechanism of redistribution is contrary to minimal government libertarian principles.

The best solution seems consist of the continual issuance of money by the producers, (as defined in the more realistic monetary economy,) and, in order to prevent inflation, be attendant by the extinction of money among the consumers.  This is another way of saying money is taken from the consumers and returned to the producers.  This requires an instrument of compulsion, a government.  Such government must remain an instrument of the (real) producers, or it will fail to adequately return demand to the producing sector, and the economy will increasingly, de facto, approximate the character and trajectory of a libertarian society, and collapse.    

Two final notes:

1) Principle never stood in the way of profit. For instance, there is profit to be made from slavery, that is, the violent appropriation of the ‘ownership of self’ by others.  It took a war to establish the principle, and overcome the profit.  And there is profit to be made from the violent appropriation of property. In the absence of a mechanism to enforce principle, principle is empty. While libertarians enunciates the doctrines of “(1) maximal equal liberty understood as self-ownership or noninterference,” and “(2) strong, inviolable property rights without regard to the pattern of distribution of those rights,” the ‘libertarian state’ libertarians promote provides no effective mechanism to guarantee these rights.  Indeed, the very existence of such a mechanism is anathema to Libertarianism. 

So the preservation of individual rights, civil, political, and economic, requires a mechanism to guarantee those rights:  A government. This government requires a sufficient input of real resources to both to maintain itself, and to be able to act to effect such guarantee. It must also answer to those whose rights it guarantees.  Where the input of resources to this government erodes, or where that government less and less answers to the people, so must the rights of the people that government guarantees, erode. 

2)We will divide the functions of government into two:  internal and external.  We will suppose the external functions of government to be a net consuming sector of the economy. That is, any society with external functions of government has less wealth to distribute among its members.  That every society, or more certainly, almost every reasonably complicated society that we have ever known of, has had these external functions of government, despite the net cost, suggests that at least the leading members of those societies considered those functions necessary.  

Suppose now that all the internal functions of government were necessarily a net consuming sector.  That is, any society with a government would necessarily have less wealth to distribute among its members than a society without the internal functions of that government.  There are two possibilities.  The internal functions of government are used and maintained as an instrument for the oppression of the majority of the people by some ruling elite, to that elite’s profit.  That is, the benefits of those internal functions to that elite would be greater than the cost, to that elite, of maintaining and operating those functions.   Or, it would be preferable to the members of that society to have no internal functions of government, since then they wouldn’t have to pay for any functions.  That is, the people would be better off, and presumably choose, the internal functions of the libertarian state.  (Except, perhaps, for internal functions to enforce taxation to support the external functions.)  However, we have not seen this, or at least have not seen it perpetuated often enough for it to make the record, so we must assume that such an internal libertarian state must be unstable, and evolve as described above. (One possible example, though, might be the Old West.  Which raises other issues.)