Lots of things have been suggested to explain whats wrong with economics, so first of all let me say what the problem isnt. The problem isnt that economics models complex real-world situations with mathematical abstractions. Plenty of sciences do that; simplifying complexity is how we come to understand it. The problem isnt that economics puts a money value on everything. Money is basically a measure of how much of a crap people really give about things, as opposed to wishing other people gave a crap about them; consider the saying put your money where your mouth is. The problem isnt that economists dont recognise the intrinsic value of natural systems (in the landscape, the biosphere, or the body). Value is about choices, priorities, and meanings, and those are people things, not world things. The problem isnt that the models require people to act selfishly. People do act selfishly quite often thats why moralists everywhere have always had to tell us not to but, more to the point, the logic of making and saving money applies regardless of whether its for you or for someone else. The problem isnt that economists are all bourgeois intellectuals seeking to maintain the class structure that upholds their power. That might explain why errors have been made and not corrected, but not what the errors are. And the problem isnt that economics assumes rational actors whereas people are in fact stupid but thats getting closer, except for the stupid part. People dont behave the way economics presupposes they should. Im going to have to go into a bit more detail here.
Heres the foundational principle of economics. Suppose you want to sell your car, and at the same time Im looking to buy a used car and yours has all the features I want. Now, Ive decided, in the privacy of my head, that Im willing to spend up to $4000, but no more. You, meanwhile, in the privacy of your head, decide that youll accept $2500 for it, but no less. We dont tell each other this; instead, I offer $3000 and you accept. Deal done. You now have $3000 where you previously had a car worth $2500 (to you), so you have gained $500 by the sale. I now have a car worth $4000 (to me) where I previously had $3000, so I have gained $1000. In total, $1500 has appeared out of nowhere, the product of our different private valuations of the car and the fact that we were able to make a transaction. We can call this $1500 surplus value.
Next, we apply the principle to a whole population, all with different values in their heads for the goods they are buying and selling. Buying a used car from a friend is something you might do half a dozen times in your life at most. Someone selling coffee will certainly be wanting to do it more than once, and to many different people who will all have their own personal idea of how expensive it would have to get before theyd rather keep the money and go without. The seller will have their own private minimum price, but the higher they go above that, the more potential customers will decide its too expensive and not buy any. Not only that, but there will be a whole lot of other people selling coffee too, and many of them may have a lower minimum price to sell.
Buying and selling exert forces on the market in which they occur. Lets imagine a free market, where everyone can choose what price they personally like, and no-one can force anyone elses choice. Suppose theres more coffee being offered for sale (supply) than people are buying (demand). The first seller to sell below everyone elses price will net a whole lot of new customers and make a big profit. So the market price will come down. Suppose, on the other hand, people want more coffee (demand) than there is to be had (supply). Sellers will find themselves running low, and put their price up so that they can make a decent profit from the little thats left; the market price will rise accordingly. At some point in the middle, the amount available for sale will equal the amount people want to buy, the two forces will cancel out, and the price will be more or less stable. This point is called the equilibrium price for that market. Because the supply equals the demand, the coffee is neither being wasted nor running short, which is what economists call efficiency.
Now, the whole point of a simplified model is to pick out particular factors and examine their effects one by one. In this case, we vary the price while holding constant all other reasons for drinking or not drinking coffee. We assume that the reason people are choosing to buy or not to buy, to sell or not to sell, is because of the price. Every potential buyer has their own subjective maximum price, above which they wont buy the coffee; our lecturer called this price the buyers willingness to pay. If the actual price of coffee is below that, theyll buy it; if its above, they wont. Likewise, every potential seller has a subjective minimum price their willingness to sell and theyll only sell coffee for that or above. So with that in mind, look back up to the used-car example: the total value created by any sale equals the buyers subjective price minus the sellers subjective price. Surplus value is not created by goods sitting in storage past their use-by date, and its not created by goods running short. The efficient price, the one which results in no waste and no shortage, is also the one which creates the maximum surplus value. The free market means that those who are most willing to pay are those who end up taking the goods home, or enjoying the services.
Ive now got about as far as I can get without drawing some graphs. Lets carry on with the coffee example. Economic graphs always have price on one axis and quantity on the other, quantity being how much of the good or service gets sold. Since economists are supposedly manipulating prices to see what happens to quantity, price should really be the horizontal axis and quantity the vertical axis, but economists just decided theyd be different, I guess, and now the opposite way is the convention. I have redrawn all these myself, mostly from memory, so plagiarize them at your own risk.
First, well look at individual buyers and sellers. We arrange the buyers from left to right starting with those who have the highest willingness to pay. In this instance, Angela would still buy coffee if it were $6 a cup; Barry would quit at $5 a cup; Cathy wouldnt pay above $4 a cup. As it happens, coffee in their market costs $3 a cup, so all three have bought one. The total surplus value between them is $6: $3 (Angela) + $2 (Barry) + $1 (Cathy).
So what does the graph mean? Where the demand curve and supply curves cross is the equilibrium price (on the vertical axis) and the equilibrium quantity (on the horizontal axis). If the price rises above this, buyers will pull it down; if it drops below, sellers will push it up. In reality of course therell be a time delay between price changes and buyer responses, and it will wobble around the equilibrium point. Note that sales happen only to the left of the equilibrium point; to the right of that are the potential buyers for whom the market price is too expensive, and the potential sellers for whom its too cheap. Neither of them will be doing any business.
Whats happening here? The government is collecting its dollar for each coffee sold from the sellers, who have passed some of the cost on to the buyers. So far, money is just getting shifted around. But because less coffee is being sold than before, there are fewer sales to collect those dollars from, and some of the value has disappeared entirely. How much, is shown by the grey triangle on the graph. Our lecturer called this a deadweight loss.
Alas, it is not that simple. Let me introduce a fourth seller, who Ill call Grace. Grace falls to the right of Frank on the graph. Her willingness to sell is $4, so she opens her coffee business only after the subsidy takes effect. Actually, shell have to shut up shop again once the others lower their prices to pull in more customers, but there will be other sellers, in between her and Frank, who will still manage to turn a profit. But where is that profit coming from? Somebody has to be covering their costs, and clearly its the government. So now the government (and through them, the taxpayer) is suffering a deadweight loss.
The graph below shows what happens. At the left-hand end, a certain amount of value is transferred from the pockets of employers to those of workers. But those firms whose willingness to pay falls below the minimum wage simply dont employ people. As a result, there are fewer jobs around, and a lot of would-be workers end up unemployed. Once again, we have a big deadweight loss to society in terms of potential surplus value.
Have you spotted the problem yet?
Ive been slightly sneaky. Ive been talking about surplus value so as not to give the show away. In fact in an individual context economists call this utility; and, aggregated across a community, the term our lecturer used was welfare. Now do you see the problem?
Note-takers are not allowed to ask questions in lectures, and, unbelievably, not one of the students said anything. If I had been a student in that class, I would have had my hand up immediately, and said something like If youre going to call this welfare, shouldnt you distinguish between willingness to pay and ability to pay? If your weekly income drops (or costs go up) by $100, are you really just as unhappy is your welfare just as compromised if that was one hours salary, as you are if it was half your benefit? Most willing to pay, my nostril. The free market means that the rich people end up with all the goods and services.
See, the first ever economic lesson I ever learned wasnt at university; it was in Sunday School.
And Jesus sat over against the treasury, and beheld how the people cast money into the treasury: and many that were rich cast in much. And there came a certain poor widow, and she threw in two mites, which make a farthing. And he called unto him his disciples, and saith unto them, Verily I say unto you, that this poor widow hath cast more in, than all they which have cast into the treasury: for all they did cast in of their abundance; but she of her want did cast in all that she had, even all her living.
Weber measured how much of an increment to a given stimulus it took to make a just-noticeable difference in a subjects perception, and found that it was proportional to the existing stimulus. That is, if youre holding a 10kg load in your arms (two bags of flour), the amount of weight you have to add to that load so that you just notice the difference is twice as much as you would have to add if you were only holding a 5kg load (one bag of flour). Fechner, his student, claimed that the same mathematical relationship applied to any change in stimulus, whether it was just noticeable or not. So if you start with a 5kg load, and double it to 10kg, you would have to double it again to 20kg before it felt like you had added the same amount. The same applies, roughly, to light, sound, temperature, and various other stimuli. Fechner called these ideas, put together, Webers Law (they still talked about laws in psychology in the nineteenth century). Nowadays it tends to get called the Weber-Fechner law, and is considered to be an approximation that provides a rough estimate in most cases, rather than something you can hang exact predictions on.
Whats this got to do with money? Since the 1970s, the prevailing theory (due to economist Richard Easterlin) has been that money in absolute terms creates happiness only up to a particular threshold, above which its all about comparing yourself with other people. Recently this idea has been challenged; it appears that money affects life satisfaction logarithmically that is, if youve just doubled your annual income from $30,000 to $60,000, youll have to double it again to $120,000 to experience the same lift in satisfaction. In other words, cash value increases well-being according to the Weber-Fechner law. Jesus was right.
Whats particularly odd is that economists are entirely capable of applying this kind of reasoning to goods and services. They know perfectly well, for example, that going from no car to one car improves your life much more than going from one car to two cars does, and they factor your higher willingness to pay into their calculations. They even have a term for this: the law of diminishing returns. Yet, for reasons I do not understand, they dont factor it in when theyre talking about accumulating money instead of stuff.
Why should they? What would happen if they did? Well, it makes our calculations of welfare very different, for a start. No more can we conclude that maximizing well-being is merely a matter of filling in all those spaces on the graph. It really matters who gets that surplus value, and how much they were worth beforehand. We can take it as a general principle that creating a given amount of surplus value will be of greater benefit the less the person had to begin with. An after-tax pay-rise of, say, $60 per week will create a lot more welfare if it goes to someone who doesnt have much (as in a minimum wage increase) than if it goes to someone whos already rich (as in a tax cut). In many cases, it will more than compensate for the deadweight losses weve just seen.
To be fair, one of our lecturers was researching what went wrong in 2008, and he was open to the idea that classical economics was not quite onto it though, as he said, if you want to criticize the orthodox theory you have to learn it first. He briefly discussed a school of thought called behavioural economics, which apparently is generating some interesting alternative theory. In particular, he told us about this study of freelance New York cab drivers, who, it turns out, do exactly the opposite of what rational-actor economic theory says they should.
The standard economic prediction is that a temporary increase in wages should cause people to work longer hours. This prediction is based on the assumption that workers substitute labour and leisure intertemporally, working more when wages are high and consuming more leisure when its price the foregone wage is low.In contrast,
Many drivers told us they set a target for the amount of money they wanted to earn that day, and quit when they reached the target... Daily targeting makes exactly the opposite prediction of the intertemporal substitution hypothesis: When wages are high, drivers will reach their target more quickly and quit early; on low-wage days they will drive longer hours to reach the target.The field data, recorded from cab meters and drivers tip sheets, supported the daily targeting hypothesis. By the standards of classical economics, the cab drivers were behaving irrationally; they were not maximizing the amount of money they could make. The authors suggest that loss-aversion is the underlying motive. That is, the drivers were not too excited about going above their daily target, but they were very concerned about not dipping below it. With the widows-mite principle in mind, this begins to make more sense. The less money youve made lately, the more difference each dollar lost makes; the more cash youve got in hand, the easier it is to decide youd rather take the afternoon off.
Now, this makes an absolute and utter hash of the last graph I showed you above, about a free labour market being better for workers than a minimum wage. It means the labour market has whats called negative elasticity, which is to say the supply curve slopes backwards: workers will supply more labour the less they get paid. There is no equilibrium price. The employers best option is to pay only just enough to be better than unemployment. Granted, if there are other employers offering better, workers may jump ship. But those other employers will not be competitive, because theyll be pouring money into wages instead of capital and extracting no more labour. The nastier ones will win out, in a rapid race to the bottom. And if you dont think things would ever work that way, take a few moments to research what labour conditions were like when there wasnt a minimum wage or an unemployment benefit. Charles Dickens makes it look rather more cheerful than it really was.
Was? Sorry, I forgot about the Third World for a moment there. Is.
You can imagine just how easy it is to save up and start your own business under such conditions. So one major effect of a free labour market is to split society into a business class, who could probably take fairly large losses on the chin really, but why would they want to? and a working class scraping and struggling for every meal. When you segregate society into classes, people on either side of the boundary tend to dehumanize those on the other side the ugly aspect of human nature known to popular-science types as tribalism and to the trendy-humanities crowd as othering. Add to that the psychology of self-deception and cognitive dissonance (nothing is ever my fault); add the fact that health-care and nutritious food are expensive, as is sanitation if the law doesnt require builders and landlords to provide it; and you end up with the myth of the undeserving poor, who prefer being dirty and slovenly to honest toil, and whose best remedy is a good kick up the sacral bone. None of the economics lecturers said anything like this, but my long experience of arguing with people on the internet leads me to expect someone to chip in with a suggestion that we can cancel out the widows-mite effect by weighting different peoples well-being according to how much theyre willing to contribute to the economy right about... now. My answer is here.
One could argue, slightly more soberly, that large-scale entities with lots of money should still get the benefits of the free market, because theyre better able to put them to use in productive enterprises; that even if we dont concern ourselves with the welfare of the rich, we should care about their ability to employ other people. The flaw with this reasoning is that concentrating money among a few rich people doesnt create demand. Henry Ford became the success story that he was because he understood that his workers were also his customers, and paid them accordingly. If that money had gone to a couple of dozen executives instead, let them be as generous and socially aware (or as recklessly spendthrift) as you please, they would not have bought a thousand Model T Fords each. The money would have ended up sitting in their bank accounts instead of stimulating production.
Whats wrong with (orthodox) economics, therefore, is that it ignores individual costs and benefits as long as were maximizing surplus value for society as a whole. Free market logic, in a word, is fatally collectivist. Perhaps we might learn some lessons from a theory centred on concern for proprietary rights, namely Marxism. I believe Marxism puts the cart before the horse in making class warfare the cause, rather than the result, of capitalism, but I think its perspective on power relations in the workplace may hold some useful insights. In Marxist analysis, the difference between raw materials and a finished product is that someone has put labour into the finished product. Therefore, the labour is the source of the surplus value (measured as the price of the product minus the cost of the materials), and the labourer is the rightful proprietor of that value. Business owners who take the bulk of that surplus value for themselves and dole out a fraction of it to their workers in wages are neither more nor less nor other than thieves.
Im going to have to interrupt myself here, unfortunately. Any economics graduate whos been reading this post with a hostile eye will have just closed the tab in disgust, having pegged me as one of those campus Marxists. Some of my best friends are campus Marxists, but, with all respect, I cant in honesty take their line. Twentieth-century radicals from Vladimir Lenin to Robert Mugabe tried to improve society through armed revolution. Not one of them, and there were dozens, achieved anything better than a dictatorship. That tells us something, but what?
I was taught not in my lectures this time, in a Social Studies class at high school that global communism had collapsed, a few years previously, because it didnt reward hard work. Perhaps it didnt, but Dickensian capitalism is not fantastic in that regard either. A better explanation of the chronic shortages in the communist economies is that prices in a market carry information about which commodities are needed and which resources are running low. A central bureaucracy, no matter how benevolent, cannot transmit that kind of information around in time to respond to needs. But the fact that a car wont move if you weld every part to every other part, doesnt imply that it will run best if you undo all the bolts and throw them away. There is an optimal amount of state control somewhere between 0% and 100%.
I think the central problem with the Marxist programme began with the rather pedantic point Ive already mentioned: Karl Marx and Friedrich Engels believed that the class divide was the root of human suffering, and that removing it by any means would abolish power differentials and violence of every kind. After a suitable transition period of mopping up the remaining threats to worker co-operation, of course, and theres the rub. If all strife arises from class division, then anyone making problems for the transition state must logically be an agent of the deposed regime. Thus legitimate dissent becomes treason.
Usually, however, the problems begin well before the new state is established. A rebel group wishing to wrest power from the government must at some point gain the support of the public, and there are two ways to achieve this: sympathy, or fear. Even before Marxism came on the scene, revolutionary movements that chose fear (the English Civil War, the French Revolution) reliably ended up installing dictators (Oliver Cromwell, the Napoleons) instead of advancing the cause of the people. And its not hard to see why. Even well-meaning leaders tend to try and increase their power, so as to be able to do more good. If the people are too afraid of them to restrain them, well, theres only one way thats going to go. And if you think its your mission to abolish an entire social class, lets face it, youre going to scare people. Thats my best guess at why the Communist Party always ends up becoming just another ruling class. Peaceful civil disobedience movements, or those that (like the American Revolution) take up arms only under threat, may not achieve Utopia; but nor do the violent ones, and at least the peaceful ones dont create Stalins or Pol Pots. If you need to rely on public sympathy, there are firm limits on how much power you can grab for yourself.
But none of that has a direct bearing on the rights and wrongs of wage labour. Marx could have been completely wrong about class, and still right about that. One key question, as youll have spotted, is the origin of the surplus value. Is it created by trade, or by labour? The problem with answering it is that value, like I said way up the top, is a people thing, not a world thing. You cant catch it as it arrives and examine it to see where it came from.
Lets have a look at the two ends of the spectrum. The used-car example above would be at the trade end. Neither one of us has done a smidgen of work on the car, and yet just passing it from you to me, and $3000 cash from me to you, created $1500 of surplus value out of nowhere. At the labour end, consider slavery on an eighteenth-century sugar plantation. The slaves net gain from the transaction is surely negative, and the owner contributes nothing except the whip. The value here is clearly derived from the slaves labour. Of the many differences between the two situations, which is the one were concerned with?
In the car example, remember that the surplus value represented the difference between your valuation of the car and mine. You were prepared to sell for $2500 or more, I was prepared to buy for $4000 or less. The trade worked because neither of us had the power to force the others hand. Suppose now that you were desperate, that you were so behind on rent that it was sell the car or live in it. I could now offer you $2000, and you wouldnt have much of a choice in the matter; youd just have to pray that you could find the extra $500 somewhere else before the end of the month. In this situation the money is worth a lot more to you than it is to me Im not going to be sleeping under a bridge if I dont get your car for under $4000. Whether you look at it like that or as a subjective manifestation of the Weber-Fechner law, youre losing a lot more than Im gaining. This is no longer a positive-sum transaction. Im stealing from you.
At the other end of the spectrum, the slaves cannot choose to bow out. The rewards to them could not be considered fair by any sane person. They suffer pain, fear, and privation at their owners hands. It all boils down to one thing: the gross imbalance of power. If slaves had fought back on a large scale, things would have changed drastically, immediately. They mostly didnt, because the owners had the power to beat, mutilate, and kill them if they tried.
Starving slowly, sleeping outdoors, suffering crowd diseases, losing your dignity as a person, are not quite as bad as being beaten, mutilated, or killed (or the slaves would have risked the latter to avoid the former). But they differ chiefly in that they erode your bodily integrity and your capacity for happiness over weeks or months instead of seconds. And these are things that happen to supposedly free people under Dickensian conditions, if they lack income. Which, if youre their boss, is a potent threat to hold over their heads and stifle negotiations. Under such conditions, the concept of employment as a free trade between equal partners is an absurd fiction.
So we can draw a few conclusions. First of all, those right-wing pundits who say that inequality stimulates the economy (our lecturers didnt) are talking through Ill be polite their hats. You could argue that from Easterlins idea that people above subsistence level are only trying to keep up with the Joneses, but, as youll remember, Easterlins idea has been challenged. I suspect it might apply, to some degree, when very rich people try to get even richer. But people who are very poor, want to get richer because theyre very poor. They dont need to see other people being very rich to get the idea.
Second, redistribution of wealth from the rich to the poor, even if it results in some loss of cash value in the system, tends to increase human well-being. Further, by increasing the spending power of the majority, it stimulates demand and hence production. When rich people are allowed to indulge their natural inclination to hold on to their riches, the economy suffers. That isnt to say that central government will necessarily be the best redistributing agent; I came to this job from the sickness benefit, and Ive seen first-hand the systemic incompetence of my countrys income support system. I believe that the government should make partnerships with community groups on the ground, who know what theyre doing and whats best for the people they work with. Id like to see unions involved in finding work for people who are unemployed, for instance.
Third, power in the workplace matters. Ive mentioned Michael Shermers 2008 Scientific American paper, Do All Companies Have to be Evil?, elsewhere, but now Ive discovered it was also published in Nature, so this time I can actually link you to it. Here is the wrong way to do things:
Enamoured of the notion of survival of the fittest, [Enron president Jeffrey Skilling] implemented a policy at Enron called the Peer Review Committee (PRC) system, known among the workforce as Rank and Yank. PRC was based on the mistaken presumption that people are primarily motivated by greed and fear. Skilling ranked employees on a scale of 1 to 5, with 5s being given the boot. As a result of this strategy, 10 to 20 percent of his employees got axed every six months, leaving everyone on edge and in a state of anxiety over job security. The formal reviews were posted on a company Web page along with a photograph of the employee, increasing the potential for personal humiliation. Those who received a 5 in the relative ranking system no matter how good their absolute performance may have been were automatically sent to Siberia. From that purgatory the 5s had two weeks to find another position at Enron, after which they were out the door.And here is a way that works:
The Google environment accentuates amity and attenuates enmity by minimizing corporate hierarchy and maximizing cross-pollination among people in different departments. Because everyone realizes they are an equally important part of Googles success, no one hesitates to skate over a corporate officer during roller hockey, explains a statement on corporate culture employees are encouraged to read. Googlers are even expected to devote 20 percent of their time toward exploring new ideas and projects, without hierarchical supervision. A horizontal corporate structure generates an atmosphere of equalitarianism and nonelitism that taps into the environment of our Paleolithic ancestors, who evolved in what are believed to have been largely egalitarian bands and tribes.We figured out centuries ago that dictatorship doesnt work for states. Isnt it about time we applied the lesson to business as well? I dont think even Google has taken the next step, and afforded employees democratic input into financial decisions. Oh, I can see the objections. Theyll blow the budget on stupidities, theyll put 100% of the profit into wages, etc. You know what? Thats what people used to say about democracy in the state, too. And yet we found a way that worked. Workers want money today, but they also know theyll want money tomorrow, so theyll generally vote enough capital investment to keep the business going. If they dont, and the business folds, thats legitimately on their own heads. When we in New Zealand changed our electoral system in 1996 to give minor parties a fairer go, people voted in a three-ring circus exactly once. After that, you learn what works and what doesnt. Id give a related answer to the objection that workers would give themselves six-day weekends and three weeks off work every month. Workers who know the connection between profits and wages will be well motivated to keep producing.
Well, thats about half of whats wrong with economics. The other half, however using economic growth as a measure of financial well-being on a finite planet has been much more thoroughly discussed elsewhere. I may talk about it myself some other time, but as I claim to update this blog roughly fortnightly, and its now been over a month, its time to get this into the aether.