EcoWarrier
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- May 28, 2012
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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-exc...punged-from-neo-classical-economics/#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.
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-exc...punged-from-neo-classical-economics/#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.
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