Economics for Humans (5): Rent, the Farce

An editorial (run during the week of December 22, 2003 in the Notional Pest) by the noted international economist, Jeffrey Sachs, provides the occasion for a new topic in this series: the concept of an economic "rent".

Before turning to the topic itself, let me remark that it is significant that Sachs has chosen to weigh in on the side of "it's the oil, stupid" in the discourse on the motives for the latest Iraq war. Many on the left, right and plain wacko have made the same argument but Sachs is a charter member of the free-floating, largely Ivy League educated, cadre of economists who have the ear of the bigwigs at the World Bank, the IMF and sundry more local talkshops. We at NETWIT largely agree, to our surprise, with his view that the US is heavily motivated by oil interests and the importance of shifting away from oil as an energy source. Where we depart turns on this notion of economic rent.

A "rent" in economics is not restricted to landlord and tenant arrangements. The term is used to denote any payments to the owner of a resource that is greater than the minimum the owner would accept to make the resource available to the economy. First-year undergraduate economics texts love talking about the rents accruing to sports stars, for example. Wayne Gretzky, one may surmise, would have played for free; his actual multimillion dollar salary was pure rent. In landlord-tenant relations it is the "economic rent" portion of the (common-usage) rent that causes all the bother: the amount that's greater than mortgage, utilities and maintenance expenses.

So, what's so special about rent? Well, it follows from its definition. If you have money over and above the cost of the resource (whatever it is) you have complete discretion over what you can do with it. It doesn't have to go to defraying any costs. Here's what businesses learned to do with their rents: buy political influence to keep the source of the rents in pace or enhance it; buy lawyers to enforce the laws; buy judges to interpret the laws "correctly"; and buy the rest of the justice system, if necessary. Some took their rents overseas and bought compliant rulers. Now, see what's so special?

The media dumb down the concept as "windfall profits". This pleasantly bucolic phrase nicely obscures the legislative fence shifting and wind-assisted shower of "apples" that don't come about by accident.

One of many notable Austrian contributors to political economy is Joseph Schumpeter, who offered the most plausible account of the real nature of competition in modern industrial economies; viz. a competition for rents. While those conventional economists who recognize that actual economies are not composed of uncountable tiny firms but huge lumbering behemoths nevertheless smugly assert that most rents are dissipated by the rivalry among the oligopolists or the threat of market entry. This is not the place to prick this particular hot air balloon (a piece is in preparation.) Instead I focus on the two outliers: the champions of rent, which each garner their stupendous rents for very different reasons.

The two industries that have maintained the highest reported profitability for the longest period are oil (by which we mean oil and natural gas) and pharmaceuticals. The bulk of this piece will concern oil, so I'll talk about drugs first.

The rents available to the drug business are due to the patent system. Those who read the earlier "Let's Hear it for the Ignorance Economy" will have already become acquainted with the way economic jargon has come to serve the commodification of knowledge. That's at the heart of the modern patent system.

At its inception the patent system was a useful development which served the rapidly expanding industrial economy. But not for long. It became the plaything of the courts and, very quickly, a tool for the mighty rather than for the small innovator. Now, the front lines of the "globalizing" economy is the expanding sphere of "intellectual property" rights; this is where the action is. Genetic engineering and software will become increasingly the source of business value and rents while drugs will spiral ever upwards.

It's a wonderful spiral of money and influence. Using the rents from patent-protected drugs, which have a marginal cost of close to zero, and sometimes sell for multiples orders of magnitude higher than production costs, the drug companies get more and more favourable statutes and regulations, backed by an army of vicious lawyers and a complicit judiciary. This makes it ever harder for any new firms to break into the charmed circle and ever more difficult for the HMOs and physicians entrapped (but remuneratively) into the preferential prescription of patented drugs and their approval by clinical trials to break free (assuming they would want to).

As splendid a source of rents as the world of drugs is, it pales besides oil. This is not obvious in the financial reporting but consider: most of the world's oil has no production cost (geological pressure forces it out, once the underground pool is breached) and commands a substantial price as soon as it leaves the ground. Currently oil fetches about $20(US) per barrel; for most oil, which only requires geological pressure to spurt to the surface, that's $20 free and clear. Pipelines and other transportation, refining and sales of refined products are each their own centers of profit.

What about exploration? Isn't that costly? And those tar sands and oil shales? Those dreadful environmental regulations? Yes, but the industry has obtained from compliant governments over many years favourable tax treatments that mean that the industry only spends 5 cent dollars on these activities. The main dodges are "depletion allowances", whereby reductions in the value of the discovered oil can be subtracted from income, using suitably arcane and generous accountancy.

The final piece of the sham puzzle is the dodge known as 'transfer prices" whereby the "resources" side of an integrated multinational, like Shell or Exxon, charges the refining side the world price (plus transportation) not the costs of production. This would be like the old Ontario Hydro generating division charging the transmission and distribution division the highest world price for generated power rather than the actual costs of production (which is what was done - and what in fact, in a nutshell, the so-called Ontario market sought to do - go figure).

So, with a poker face, the oil industry puts those pie charts on the pumps showing all that tax and a tiny "profit" on the retailing of gasoline. Whereas the "crude costs" are themselves 90% profit, plus another 15-20% on the refining and transportation. Our guess is that per dollar of gasoline sold the integrated oil company accrues about 25 cents in rents, not the 1or2 cents their pie charts claim.

We pick two nits with Dr Sachs. First, don't call Dick Cheney naïve. Call him evil, call him nasty but naïve he ain't and we suspect Dr Sachs knows that. "Mr Cheney's view is technologically naïve and politically disastrous.", says Sachs. By technologically naïve Sachs means Cheney doesn't appreciate the availability of technical alternatives to oil. What Cheney does know is none of the other technologies generate anything close to the rents of oil. As to politically disastrous..to whom? The good old boys are doing ok.

Second, this matter of rent. And it's related. As mentioned, Dick Cheney and the other Texans that have become part of the US elite understand very well that nothing generates free money - rent - like oil. Using the bought political and judicial influence the US oil majors have effectively created a perpetual money-machine; depletion allowances and secret geological data mean that they spend 5 cent dollars on exploration with a leg up on any rivals; the crude production is almost pure profit; and, control of refining and transportation generates healthy profits from these parts of the business too. All that free money then buys yet more political and judicial and bureaucratic influence.

Technological alternatives to oil will never produce that kind of lucre! All of them are essentially manufacturing processes; these industries make money, sure, but nothing close to oil or drugs. Thus is why wind power, solar power, fuel cells, etc. etc. are always on the horizon and have been for thirty years but never quite get into the foreground.

The same goes for coal, except that coal held a historical foothold before oil swept all before it, and some types of coal are both relatively cheap and have labor union clout to keep the mines and pits open or still have unique metallurgical uses (mainly in steel production). The oil industry will only allow these to take a substantial share of the market when oil production goes into decline and they have developed enough market control to reap rents from the higher prices that the alternative sources will then command.

Forces much larger than Cheney are behind US foreign policy and always have been. Oil interests have loomed large in US foreign policy for a hundred years. We don't know exactly how this shadowy world works (if we did we wouldn't be both alive and gabbing about it on the 'net)…A dog's breakfast of factoids is available: oil pools in the Caspian basin rivalling the Middle East, pipelines East to China, south through Afghanistan and Pakistan west to Turkey, through Chechnya, a tottering house of Saud, Russian oil billionaires, mucho oil offshore of N Vietnam, etc.. Only the players know for sure what is known and what is fiction and they ain't saying. Won't ever be saying.

All we know is nothing greases the military and political wheels like oil rents. Speculation is an endless game; okay if you're paid for writing articles about it but useless as analysis. What, then, is a citizen to do? Fade the lights, cue the music, here comes Roy Harper: "If all of this supersale overkill world is for real/there's nowhere to go, you might as well start to free-wheel". Oh, that and keep a good chunk of major oil company stocks in your portfolio.

Economics for Humans (5): Rent, the Farce © Hector LaPaunche, 2004

Economics for Humans (4): The Price is Right

"In the center of the ring
They are torturing a bear
And although it cannot sing
We can make it whistle 'Londonderry Air'
And the price is right, the cost of one admission is your mind"

– The American Metaphysical Circus, The United States of America

In this series so far I have dealt with the main concepts of economics with respect to the supply side of the economy. The unfolding debacle of electricity system restructuring provides a perfect context in which to begin to unravel the threads of the intellectual frauds that constitute the cloth of consumer theory in modern economics. We at NETWIT particularly enjoy the truly Greek irony involved in the collapse of the dream of "competitive electricity markets" .

The premise of this neo-conservative fantasy is that electrical energy can be "unbundled" from the wires that deliver it and that electrical energy is a private good. The irony is that the truest of blue economists that have provided the rationale for this are those most given to "physics envy" (an average paper in the American Economic review uses more advanced mathematics than Einstein's famous 1905 paper on special relativity) yet they have been undone by their failure to acknowledge the physics of electricity.

Back in the early days of economics, it was not so critical for Ricardo, Smith and even, later, Marshall, to define precisely what they meant by a "good" or "commodity". Their aspirations were not to build a "science" but to develop some useful concepts about trade and business. Then came the "marginalist revolution" led by Jevons in England and Walras in Austria, who explicitly modelled their concepts and mathematical formulations on the physics of the day. The key idea, that economic decisions in consumption and production should be based on the value of the last or "marginal" unit consumed or produced, was driven by a desire to ape the success of the application of calculus to physical problems.

The powerful image that still dominates the modern textbooks is that of the Walrasian auctioneer. The idea is that market exchange in a self-regulating market economy (or "free market" in the language of the neocons) may be understood as a number of simultaneous auctions. Each market is "cleared" by the last "bid" for the last available unit of each product and this is the applicable price for that product. Somehow the bidders are aware of all of the other prices when they bid for each product.

This is an undeniably neat scheme and it has entranced several generations of economists. So much so that they have ferociously dismissed any nitpicky criticisms as lacking in the mental capacity to understand that this is an "as if" model, the explanatory power of which is so great that all reservations as to how it corresponds to actual markets are beside the point. Some of us are incorrigible, however. We see them nits and...pick, pick,pick!

There are three broad categories of nits to be picked with the auctioneer model: the nature of the "commodities" that are auctioned; the period of time in which the auctions occur; and, the information available to participants. Although there is overlap among these categories, this first piece in the consumer side of the series will focus on the issue of "what is a commodity?"

It may be supposed that such a crucial concept as a "commodity" would be
defined with some rigour. While the metaphysical status of mass has been muddied by relativity and subsequent developments in theoretical physics, it cannot be denied that physicists have developed a formidable set of operational definitions and measurement protocols for mass. Not so with the equally fundamental concept, in economics, of "commodity". Characteristically, the keepers of the conventional economic flame deal with this in the same forthright manner they deal with other basic problems, such as "what is capital?" and "what is the nature of production?", which are the subjects of other pieces in this series. Which is to say they sweep the matter under the rug (for example, even the text book by the doyen of modern economists, Paul Samuelson, has no definition for a commodity.)

Let us turn directly to the auctioneer analogy to see why this might be a problem. In an actual auction the most obvious feature is that each item auctioned is specific; this is true of even bulk goods, such as tea. Just pursuing the latter example, particular lots of tea, representing a specific leaf type, farm, type of processing (fermented or not) and when picked. At an art auction every piece is specific and all auction goods, within limits of homogeneity, are discrete.

More fundamentally, commodities sold at auction are private goods. They are transferred from one owner (or group of owners) to another, for the private enjoyment of the buyer.

In contrast, goods consumed jointly are called "public goods". Economists make the distinction with private goods more precise: public goods are not "excludable" nor "rivalrous". Once streetlights have been provided no-one may exclude anyone else from their benefits, nor can anyone be said to compete with anyone else for a share. In contrast, either I eat the frog vomit truffle or you do (or we could each take a bite but each bite may only be taken by you or me – this is exclusion). If you want the whole truffle you'll have to pay more for it – this is rivalry.

The distinction between public and private goods is not clean; there is a spectrum of possibilities, with relatively "pure" private goods as rare as their public counterparts. For example, to some degree all consumer durables, including automobiles, fail to meet the criteria of complete excludability and rivalry. Very few people buy a TV set for their sole personal use and even fewer expect visitors to pay a fee for the privilege of sharing a viewing of The Young and the Restless. Most food and drink are also purchased for some sort of communal purpose in addition to bodily sustenance, from eating together as a family to eating at Maxim's as a public signal of personal affluence and attainment. As noted above, snack foods may be the only pure private good.

Because public goods are consumed jointly without rivalry or exclusion, there cannot be markets for them. Much of the neocon revolution of the past twenty years has been an assault on public goods, such as health, education, security (policing) and environmental quality. While this has produced many problems they are not so clearly identifiable as stemming from neocon policy.

In the case of electricity, the neocon economists have overstepped the mark because they have failed to grasp that bulk electricity, too, is a public good. The most obvious feature of electrical systems is that they consist of circuits. The entire system is conceptually the same as each household, except there are transformation stages in between the generators and end-users. Consider a single circuit within your household. There may be a lamp, a vibrator, a TV and a vacuum cleaner on the circuit. As long as the circuit is not overloaded then all the devices consume the power jointly. When it is overloaded none consume.

This is true of the entire bulk system. Consumers do not seek to exclude one another from using the grid or to outbid each other to own it. Either everyone consumes at the same time or entire areas (or conceivably, as happened in 1965 in Northeast North America, the entire system) consume nothing (i.e. they are disconnected). In your home if you add a hair dryer to the above circuit you may blow the whole circuit.

The eagle-eyed will have noticed that I use the term "bulk electricity"
in the foregoing. This is because electricity can be provided as a private good; this is what we do when we walk around with a Walkman or when we use a cellphone. There is only one circuit and one private user. This only goes to emphasize the intrinsic public nature of our use of the stuff that comes out of our sockets.

Bulk electricity systems are able to meet the fluctuating levels of load by means of an extremely complex system controlled by a central operator. The established practice of such system operators for fifty years or more has been to arrange hourly supply by stacking available generation in a "merit order", with the highest cost or marginal unit providing the final block of power to meet forecast load. "Haha!", said the neocons. This looks like a Walrasian auctioneer. Unfortunately, this auctioneer is trying to auction a public good. To see the complications that arise, let's look at a more familiar public good - a bridge across a river, which was also the first example of a public good, in a work by Cournot in the early 19th century.

Before the bridge is built, how would the auction go? Who will bid to pay for the bridge? How much? Well, the answers are: no-one and zero. No-one could afford to pay for a bridge for themselves and everyone would want to "free ride" on the expense incurred by anyone stupid enough to agree to pay. This is known as the "free rider" problem that is inherent in all public goods. After the bridge is built, again no-one would volunteer to set the price voluntarily. The auctioneer model just does not work for public goods.

The universal answer to these problems, since the days when there were private toll roads and bridges (and not much transport), is to build bridges with public funds and recover the costs through taxes, tolls or some combination. Now suppose, we make the bridge "look like" it is a private good by auctioning the rights to a private owner to charge tolls. Note that there is a crucial distinction between auctioning the rights to monopolize a public good and the good itself. As I discuss a little more below, there is a range of public to private goods, with streetlighting and national defense at one end and snack foods at the other. Where there are means to charge for a public good after it has been provided at public expense there are no shortage of people, doubtless out of an excess of public spirit, willing to make the collection of fees more "efficient".

Would we be surprised if that owner, instead of charging enough to recover costs, charged whatever they could get away with? This is exactly what happened in California, the original "poster-boy" (now revealed to have been heavily airbrushed) for electricity restructuring, where the electrical generators charged whatever they could until the point at which the system operator had to disconnect people. The way in which the generators "gamed" the auctioneer is somewhat complicated in its details but in its essence was simply withdrawing supply to force up the price. This would be like having several bridges between downtown and the suburbs and shutting one or more of them down at rush hour.

While bulk electricity has proven to be a case that has exposed the fallacies of private provision of public goods because of the intractable physical nature of electricity, the damage being done to other public goods is often more easily obscured by the rhetorical smokescreens of the media apologists for "free enterprise". Goods which are clearly not private are being misrepresented as private goods.

This piece has focused on the basic classification of goods as a foundation for consumer theory. In general, the worldview of economics in respect of consumers is accurately captured by the refrain from the song by the United States of America, "the price is right, the cost of one admission is your mind". To be fair, from a sufficiently "high level" metaphysical view of society, the cost of participation in any set of social arrangements is our collective rationality. There is always some set of ideas that define how people think at some point in history in some geographical space. Yet, to enter into the circus of mass-market America we all, in effect, become the atomistic, possessive individuals of Thomas Hobbes and agree to take it on faith that price is the sole determinant of value. In companion pieces I address some of the other basic difficulties that arise from applying this principle to consumer behaviour.

I do not wish to leave the impression that the failure of economic theory to withstand critical scrutiny diminishes the essential accuracy of the Hobbesian account of the human psyche in a generalized market society (but not "self-regulating" as is the neocon creed). The problem is the extent to which the Hobbesian self-image holds dominance over other images, such as humans as fundamentally social creatures. When we are engaged in an economy where value is determined by exchange for most of our waking hours, we do approximate mechanistic human atoms ricocheting from transaction to transaction governed solely by our appetites and our wherewithal to buy and sell. This cannot fail to carry over into others aspects of our lives. In this context, the provision and use of public goods serve the purpose of jarring us from our Hobbesian condition and remind us of the fundamentally social nature of human life. Since this is a series that concentrates on explaining and criticizing economic concepts, this is not the place to explore in detail the political, social and psychological significance of the tension between public and private goods but we should also not make the mistake of assuming economics exists as a separate sphere of social existence.

The institutions of the market economy could not exist without a malleable and enigmatic human nature capable of behaviours governed by possessive individualism. The true nightmare, captured in the song, is that this may be all-encompassing, a one-way admission into the free-market metaphysical circus. The failure of the attempt to force the public good of bulk electricity into the straitjacket of a private market is a welcome reversal of the trend towards rendering all of life the subject of market exchange. We must prevent the subsuming of other public goods into the maw of the private economy monster and reclaim those that have been swallowed, however far along their state of partial digestion. Otherwise the cost of admission to the utopian/dystopian vision of a hegemonic and complete "free market" indeed will be our minds.

Economics for Humans (4): The Price is Right © Hector LaPaunche, 2001

Economics for Humans (3): Nature's Wages

The editor notes: This article was published in 1999. If you're wondering whether it's worth reading, have a look at the last paragraph first.

This article concludes a trilogy on the production function. Loosely speaking, the two previous pieces dealt with the ghosts of capitalism past and present. Listen! Hear the rattle of chains? The sounds of disembodied wailing? Methinks the ghost of capitalism future is upon us.

The production function reminds us that under capitalist production output is divided into two "returns" – to labour and to the owners of capital. Those who agree with Francis Fukuyama that history has ended, in effect, proclaim the victory of the latter over the former after two centuries of strife. This may be so but the victory may well be Pyrrhic. Indeed, it is my contention that if capital has indeed triumphed over labour the eventual "triumph" of the silent partner – Nature – is all but a foregone conclusion.

Readers may recall that the "Classical" economists - Smith, Ricardo, Marshall, Mill, to name four, roughly spanning a century – identified three "factors" of production, i.e. labor, capital and – land. The dropping of land from the canons of economic orthodoxy represents one of what Galbraith has called economics' necessary accommodations to reality. Specifically, the decline of the political bargaining power of the hereditary landowner class meant that "land" no longer commanded a necessary claim on the fruits of production. Consequently, the textbooks stopped mentioning it. But the economic truth remained. Land is invariable in production and it does require a "return". Just as labor and "capital" need to reproduce themselves, so does land. Until about 1960, the size of the human economy relative to the Earth was small enough that the supply of land - and the ecosystems that cohabit with us - could be taken as limitless. We have now passed a threshold. Land - now in the guise of "environment" - demands its due. As a civilization, not as a species (it is hubris to think we can "destroy" Nature) we either pay now or pay later, in which case the wages of our collective "sin" against Nature will be death (of this Civilization).

Well this is pretty gloomy stuff. And haven't we heard this before? Well, maybe. On the bright side, I have no privileged understanding of the way the complex system called Earth works. So the curtain may get rung down in twenty years or two hundred and twenty. As Keynes said, in the long run we're all dead, so why stop the party now?

I don't have any knock 'em down, drag 'em out answers to these questions. Let me just emphasize two points before moving on to some ideas that might help to turn around the economic system, for those who may be interested. First, as noted, the sheer scale of human operations has grown enormously in two hundred years. Not just raw population but the per capita impact on the rest of Nature – as captured in the vogue idea of the "ecological footprint". A seminal study, which is unfortunately not widely known, was published in Bioscience over ten years ago by Vitousek et al. This study gave a rough calculation of the part of the Earth's annual production, from the Sun's incident energy, of "biomass" (i.e. plants and animals) that has been appropriated in one way another by humans. The estimate of the human share of "Net Natural Production" was 40% and while the authors did not pretend to any high degree of precision there has been little subsequent dispute that this is a credible number. Even if the estimate is three or four times too high, the message is the same: it is no longer possible to assume human activity is too small to affect planetary processes. Second, our admittedly rudimentary knowledge of "complex systems" is still enough for us to know that such systems undergo sudden and unpredictable shifts. Thus, it seems highly plausible that, somewhere along the line, the planetary processes governing climate and biotic composition (a fancy way of saying the number, type and distribution of living beings) will suddenly change. We are fairly sure from geology that there have been many such episodes in the past. What is new is the likelihood that this civilization's actions, rather than biogeological cycles, will trigger the next shift.

Of course, implicit in the above is the view that civilization-threatening changes will eventually occur in any event. I do not deny this. If it were the case that making changes to avoid catastrophe necessarily entail creating a dystopia, such as those in 1984 or Brave New World (or Blade Runner or Brazil), I would be the first to say, "party on dudes!" (quoting Lincoln's address to the San Dimo High class that graduated Ted Logan and Bill Preston). Instead, it seems to me that prudent actions to better integrate environment and economy (to move towards "sustainable development", to use the Orwellian phrase most often cited to capture this concept) could also lead to more democratic government, greater personal autonomy and greater equality while still supporting a high degree of material comfort. (The reader will be relieved to hear that the general human condition will remain as confused and dysfunctional as ever. Following Galbraith again, I cannot even guarantee heightened peristalsis.)

One of the claims I made at the outset is that maintaining the current economic path (of triumphalist capitalism) will hasten cataclysm. I will briefly explain why I think this is likely but, just as important, this path will also lead to a dark political future. I believe that a different approach to the relationships among the Big Three production factors (with land understood as environment) opens up the possibility of transforming capitalism into some more benign form.

The current economic path is headed for a collision with Nature because there is so little incentive for economic actors to take account of the impacts of economic decisions on the biosphere. Moreover, the conventional approaches to better integration of economic and environmental "needs" will do very little to bring the two systems into closer alignment. The first response of the modern industrial capitalist order to "environmental" problems - broadly pollution and resources depletion - was "command and control", i.e. legislated controls on the worst excesses. The problem with this approach is that, over time, the political support to increase controls and enforce existing controls has eroded. This erosion will likely continue as new approaches are proposed to give the appearance of action. These are "voluntary regulation" and "economic instruments". The former is modelled on the self-regulated professions, e.g. doctors, lawyers, mobsters etc.. While some firms have embraced "green" possibilities as more than a marketing opportunity, this will never amount to anything more than rhetoric for the great majority.

Economic instruments encompass a panoply of measures but are focused on what is known as "internalizing the externalities". In one sense, this is exactly correct. The problem is that environmental values are not reflected in money values. Alas, this is not what the economic gobbledygook means. Economics pretends to be a "science" and its theories allegedly deal with the "real economy". Economists really think that the environment is "external" rather than the actual site of all economic activity. This leads the profession to endorse the trading of pollution credits as a way to improve the environment. The intellectual underpinnings for these schemes are provided by an idea known as the "Coase Theorem", named after Ronald Coase, a recent Nobel laureate. There is a well-known joke about an economist stranded on a desert island who proposes that the solution to the problem of unopened canned food is to assume a can-opener. The Coase Theorem is reminiscent of this. The usual version is, "in the absence of transactions costs, a reassignment of property rights can solve the problem of externalities." The irony of this is heightened by the fact that the major part of Coase's work has been devoted to studying transactions costs in firms, in regard to which there is no other explanation in contemporary economics for the existence of large firms than the prevalence and size of transactions costs.

While the pollution trading schemes will do little or nothing to address environmental problems, real progress could be made through a variety of other "economic instruments". Proponents of these and of a package of "Green Tax Reform" point to a wide variety of such instruments that are already in use in the major industrial nations. These include effluent charges, taxes on energy use in various forms (e.g. on gasoline) and deposit-refund schemes. Unfortunately these are all either marginal or were brought in for entirely different reasons or both. While a true Green Tax Reform package would go a long way towards redirecting the economy, it is never likely to progress beyond the marginal stage for the same reason that Command and Control has stalled; viz., the political power of business will block any attempt to impose new costs on private firms in any guise.

The only way to address the environmental problems of modern industrial capitalism is to tackle at the same time the historical problem of the struggle between labor and capital. The root cause is the same. The power of organized capital to increase its share of economic output, which, in turn is used to reconfirm its political power, affects the economic shares and political power of labor and the reemergent factor of "environment". From where will come the political will to drive this change? The optimistic scenario is a joining of the two movements internationally. In the non-OECD world the struggle between labor and capital will remain foremost. The trick will be to find a way to build political support in the OECD around "green" issues and in such a way as to make common cause with the rest of the world. Of course, this is the very division the idea of "sustainable development" – the preferred label of the industrial elites for integration of environment and economy – tries to paper over. The difference is that the "sustainable development" agenda is simply to turn the keys over to business whereas I am suggesting we need to build coalitions to control unfettered business interests. This is where the environment as factor fits in – as an organizing principle.

This may seem highfalutin. What we need to understand is the power of ideas. Perhaps Keynes' most famous quote refers to the power of ideas of "defunct economist(s)" to permeate the thoughts of "practical men of business". Yet this does not go quite far enough. The entire modern world is the creation of the human mind. My knowledge of archaeology is admittedly spotty but I am sure that no evidence of K-Tel CD collections or Game Boy has shown up in the ruins of ancient Greece or Persia. (If it does, I may have to revise my views or call in Mulder and Scully.) The gods of those times had their virtues, no doubt, but compared to the god of the machine (i.e. the Universe as machine) they permitted a restricted range of technical accomplishment. If we believe human society should be merely a set of arrangements to allow for the smooth operation of a mechanical generalized market system then trading pollution rights makes sense. It makes a difference if we in the West think we are taking "green" actions to make markets work better or to bring them under rational control. We would then have a basis for a genuine union of "north-south" (i.e. Developed and Less-Developed nation) interests.

How then is this abstract construction "environment-as-production factor" any better than "internalizing the externalities"? How would it be brought into practice? Just as workers charge the productive enterprise for their "labour services", the "environment" would charge for its services, e.g., providing (relatively) clean water and air and physical space. (Note that this is distinct from "natural resources" which are specific inputs to the production of such outputs as, steel, lumber, diamonds, petroleum products, etc.. Environmental services are necessary for any economic activity whatever, just as for labour.) The obvious way to do this in practice would be to add the charge to the use of water. How much should be charged? This would be bargained. Who would play the part of unions? Anyone who would "speak for the trees" - including unions, should they wish to take on this mantle! In practice, all governments would need to do would be to set up (in laws) bodies that would set water fees incorporating an environmental service charge component, naming whoever are the "usual suspects" – interest groups – to the governing boards. In Ontario, for example, the Ontario Clean Water Agency could be given control over the price of water and a broad responsibility for spending the proceeds on a variety of measures for rehabilitating Mother Nature, with a Board composed of, oh, say, Conrad Black, John Fitzgerald, Buzz Hargrove, Bob Hunter, Mark Winfield (Research Director of the Canadian Institute for Environmental Law and Policy), etc.. Or some other group of persons. The point is that the creation of such a body would form a natural political focus for unions and environmental groups, since the investable revenues could be directed towards projects that could benefit their constituencies. I am not saying this would be easy but it would form the basis for a political coalition that is not possible under Command and Control or the "internalize the externalities" routine.

How would this fancy rationale for more expensive water do any good? Aside from the political benefits, which are crucial, and the ideological role of the idea in support of this, the benefits to both economy and environment are potentially enormous. The way to appreciate just how large these benefits could be is to reflect upon the fact that modern economies have been built upon the assumption that environmental services are free. Consequently, to a very large degree – despite Command and Control – our entire productive system has evolved with no regard to "economizing" on the use of environment. Again pursuing the analogy with labour, can you imagine an economy with "free" labour? It's not hard. It's been the dominant form of economy for most of human history. It's called slavery. Under slavery in all its guises there is no incentive to develop technology that saves labour: the overthrow of slavery, in the form of the feudal system, is what gave rise to what Marx called the "civilizing moment" of capitalism and the immense productivity of the capitalist system. It is the prospect of a similar advance in productivity from the incorporation of paid environmental services into productive technology that allows for a degree of optimism that this civilization can avoid decline and fall from environmental causes. (Which is not to say that other cause may not bring about this condition.) The specific practical evidence that the "win-win-win" possibilities of environmental technology is now abundant. There is a burgeoning literature documenting the success of those firms that, even with the very modest incentives now in place, have decided to simultaneously improve environmental performance, (money) cost control and profitability.

Into this optimism I must add a dash of pessimism. Neoconservatism certainly looks triumphant these days and until the expected economic "correction" arrives the task of developing the necessary political coalitions will not be easy. Indeed, I suspect that until the next economic recession (or worse) it will be difficult to get a hearing for ideas such these. Environmental calamities, too, will come along. Violent weather, which may or may not have a connection to "Global Warming", strange diseases, chemical spills, nuclear disasters – all are part of our future. Added to these, a new oil crisis will appear within the next ten years. The trick is to have non-authoritarian responses warming up in the wings. In this article I have advanced a broad economic concept around which such responses may be built, i.e. the idea of environment as a factor of production, implemented by a bargained "environmental service charge" levied on the cost of water. If I have piqued the reader's interest, this will have evoked many questions, some of which I will address in subsequent pieces.

Economics for Humans (3): Natures's Wages © Hector LaPaunche, 1999

Economics for Humans (2) Creating the Dragons of Inflation and Deficits

In yesterday's post I tried to show how the major economic development of the last twenty years, i.e. the massive transfer of relative income from wage earners to the owners of financial assets, may be understood by means of the concept of the "production function". In this article I will try to link the means chosen to effect this transfer, viz. raising the real interest rate, to the idea of economic inflation and to the vogue of deficit phobia that has held any reasoned attempt to explain or develop economic policy in a death lock for more than ten years, with no end in sight. As before, I am going to use ideas about production – one of the few useful areas of economic theory – to try to explain how we arrived at our current predicament.

Readers will recall that the idea of the production function is to express simply the notion that economic output is ultimately derived from the application of available technology to available "factors" of production.  Factors are special inputs to production that have two characteristics: (1) they are always used; and, (2) they command a "return" from the output they make possible. In the classic work on the formation of the modern economy, The Great Transformation, Karl Polanyi distinguishes three factors, land, labour and money. The "returns" to these factors are usually called, respectively, rent, wages and interest.

The factor that probably confuses more people than any other about the nature of economics is money. This will strike most readers as a bit outlandish. Isn't economics about money? Fundamentally, no. Economics is about what gets produced and how it's distributed. In the "real world", of course, money is the measure of what gets produced but, odd as it may seem, it's easier to understand what happens in the economy without considering money. People use their labour and ingenuity (including technology) to produce things. Once produced, two possibilities exist for these things: they can be consumed or saved. In particular, some things may be saved to help produce future years' consumables. These things constitute what we call "capital". While there are many unresolved controversies surrounding the precise meaning of economic capital, this account suffices to establish the important idea that output in some period (say a year) is "returned" either to people for consumption or to society as a whole as the means for future production. In either event these returns allow for the "reproduction" of the economy. Without consumption – of food, clothing, shelter, etc. – people cannot reproduce either themselves or their labour. Without setting aside some output – in the form of machines, for example – future output would diminish even with the same level of human input (labour).

Inflation arises because money prices do not accurately reflect the nature of real economic production. It's easy to see how this arises. Money is ultimately a belief system: the belief that presenting claims of ownership backed by the authority of the state is sufficient to persuade other people to relinquish their own claims. The quarter I proffer to the Convenience Store proprietor is a token of the Canadian state's legal authority such that he or she is moved to give up their ownership of the licorice pipe I desire to own. Broadly speaking, if the Canadian state creates too many tokens of such claims relative to the total amount of goods and services available, I will need more of them to take ownership of the goods I desire. Simply put, the money price has gone up and we have "inflation". The actual situation is only more complicated by virtue of the slippery nature of "money". Construed as transferable ownership claims backed by state authority, "money" may take a variety of forms: coins, paper money, cheques, and a huge variety of more exotic instruments, broadly described as "securities", e.g. equity shares, debentures, etc.. Needless to say, only the chosen are admitted to the inner sanctums of the financial priesthood to be indoctrinated in the shamanistic totems and magic utterances required to adequately master the intricacies of the latter forms of "money". Indeed, the formal accounts of the central banking authorities cut off their official definitions of money roughly at the level of credit cards.

Be that as it may, there is a further complexity that must be addressed. Under the peculiar arrangements of economic affairs that prevail in "capitalist" society, money is regarded not only as a means of transfer in ownership claims but as a factor of production, therefore a "commodity" for which payment must be made, like labour and land. Money in this guise is "capital" and the ownership claims associated with this form of money are given extra legal authority, which is why the bank can repossess your house. Unlike other goods and services or factors, capital has no real underpinning; its warranted "return" – interest – is simply a state-sanctioned payment for the rights of ownership. Consequently, when there is inflation, the value of stocks of capital, or "financial assets", erodes relative to real goods and services. This is why financiers don't like inflation. Sure they can protect themselves by indexing their returns to the general rise in the price level but there are always some assets "trapped" at lower rates of return. When inflation got into double digits in the 1970s, US financiers en masse persuaded the US government that drastic action was needed. The subsequent actions of Paul Volcker in response were outlined yesterday but the key element was simplicity itself; he jacked up the interest rate to monstrous levels, to swamp the impact of creeping inflation.

While the relationship between the paper money economy and the real economy is somewhat loose, there, nevertheless, are connections. Socking consumers with huge credit payments and drawing funds away from investment in real plant and equipment into financial assets eventually sucked the steam out of the real production of goods and services. This meant a recession.

Recessions mean less jobs and less jobs mean wages get depressed. This all took a while but by 1983 the recession was over and inflation had been lowered. How could the financiers ensure that it would not start climbing back up again?

Readers with long memories will recall that, miraculously, the free media peppered us for almost a decade with the very same message that financiers wished to get across - inflation is hell, it rots your teeth, it molests your children. Yet somehow, the unwashed hordes were strangely unreceptive. This was a hard sell. Fortuitously, Volcker's medicine for inflation set up a message that would work better. Those stratospheric interest rates very quickly caused government debt to balloon – the deficits governments were forced to run because of the Volcker recession also helped. In no time at all we had a new boogie man – the Deficit. Lo and behold, coincidentally another concerted media campaign to inform the average citizen of the evil of Government Deficits got rolling and is still with us. Since government spending has been used for most of the post WW2 era to "top up" the economy and maintain employment, slashing back on government spending has had the salutary effect of maintaining unemployment and, hence, pressure for lower wages.

Back in the real economy, the issue is this: that portion of output that is not consumed ("capital"), do we want to invest it in plants that make patty-stackers or in schools, hospitals, roads, etc.? Which provides society with a greater "rate of return" in terms of future benefits?  Deficit phobia nicely obscures these questions by screaming over and over "deficits are bad, government debt is bad". We'll examine this proposition in more detail in a future article.

In summary, the production function is a compact way of explaining that, despite the "end of history" (i.e., the defeat of communism) there really is a fundamental antagonism between wage earners and owners of capital. Output must either go as payments to one or the other. While the best (i.e. most productive) division of real output between present consumption and invested savings is an economic question of the first order, the flow of paper money payments to wage or interest claimants is, in the end, a political question. The political power of those whose wealth overwhelmingly depends on returns to capital and who control to a very large degree the allocation of capital savings among different investment possibilities has been used successfully over the past twenty years to shift the share of output towards "capital". It would be a large digression to show how political and financial power has enlisted the media in its service. All we note for present purposes is the remarkable consistency of the mass media message with the best interests of the owners of capital. First, there was the fight against inflation, then the fight against the deficit created by the fight against inflation. Throughout, the share of output going to wages has fallen. What will be the next fight? Well, there's really nothing left, except a frontal assault on wages. This is to be accomplished by two new themes that have been warming up in the wings for a while: "ineluctable global competition" and "make the welfare bums work". Sound like winners to me!

Economics for Humans: (2) Creating the Dragons of Inflation and Deficits © Hector LaPaunche, 1999

Economics for Humans, part 1: Dividing the Spoils of Production

by Dr. Hector LaPaunche, ex-Deuxième Bureau operative and scrum-half for France (the League team, we believe)

[Recent events suggest that perhaps not enough people paid attention to this series of articles back when we first published it in 1998. These events also suggest that people should pay attention to this series now. Right now. We'll be publishing one a day for the next five business days. Read them all at once, read them piecemeal, just don't tell us we never warned you.]

In my last article, I tried to explain how economists have attempted to account for technological progress and how the current vogue relies on the dubious construct of the Knowledge Economy.

In this article I will show how one of the main concepts introduced in that article, viz., the production function, is one of very few ideas in economics that is actually useful in understanding the economy. Diligent readers will recall that the production function is a fancy name for the idea that economic production, whether an entire economy or a single firm, depends upon the use of the factors of production in some ratio.  Last time I deliberately glossed over the meaning of "factor of production".  Now it's time to put this term under the microscope.

The inventors of modern economics, the "Classical" economists, notably Smith, Ricardo, Mill and (yipes!) Marx, distinguished three factors of production; land, labour and capital. These were factors in the sense that all production required some mix of the three and, in turn, each required some form of "return", called, respectively, rent, wages and interest(or, more generally, in modern finance, interest and stock or "equity" returns).  In contrast, modern pseudo-mathematical "neoclassical" economics no longer distinguishes among "inputs" to production. Along the way, from about 1920 to 1970, economists did recognize a special status for labour and capital but not for land.  What this progression
neatly expresses is two hundred years of political developments. Early capitalism pitted not just capitalist against labour but also, as is now largely forgotten, both against the landowner class. The economics texts, at some lag, dutifully recorded the political decline of the landlord by dropping "land" from the list of "inputs" that warranted some form of economic return. In the broader scheme, this reflected the declining share of agriculture in overall output, from about 90% of output 200 years ago to about 2% now.

Thus, the production function defines the tension that has dominated capitalist economic history. The production function says that capital and labour are used in varying amounts to produce economic goods. The corresponding share of the returns – wages and interest – has been the central battle of capitalism.

Seen from this perspective, recent developments become quite clear.  The post-war "golden era" saw a shift in the share of output from capital to labour.  This was tolerable to capitalists because it was accompanied by an unprecedented growth in productivity (i.e., output per worker), which meant that the
absolute amounts of money capitalists were taking in was increasing, even as their share relative to wage earners was decreasing.  This came unstuck in the 70s, when relatively high inflation meant that the value of financial assets decreased relative to the value of wages.  (We'll explain this next time).  The middle class mortgage owner in the mid 70s was doing better than the banks that loaned the money! This couldn't be allowed to persist. The boom was indeed lowered, starting in 1979, by the chosen henchman, Paul Volcker, Chairman of the US Federal Reserve.  How did he switch the balance back in favour of the holders of capital? Simple. He jacked up interest rates. Remember, the production function tells us that wages and interest rates are the eventual destination of all output. When wages get too high, make interest rates even higher to restore the balance. That's what Volcker did.

Sceptical? Well for those who like empirical proof, here is a graph of the Canadian prime rate for the major banks from 1935 to 1985.



The graph shows the rate of interest that underpinned the Canadian economy during that period, since the prime rate moves in lock-step with the Bank of Canada rate, which is the rate the central bank charges the private banks. A graph of the corresponding US rate – the Fed's discount rate – is pretty much identical.  The
rates set by the two North American central banks are important because they set the "floor" for the return to capital.  Actual rates of interest vary enormously according to the perceived degree of risk associated with the investment involved. Typically, equity investments (stocks) require a higher rate of return than debt.  While the actual rate of return across the whole economy is the weighted average of the return to all categories of invested capital – a fiendishly difficult quantity to estimate, even by the lax empirical standards of economists – the movement of the central bank rates may  safely be taken to represent shifts in the total return to capital, since all of the riskier investments adjust to the "riskless" central bank rate.

The graph is very striking but the rapid rise beginning in 1965 obscures the effects of inflation. When inflation is considered, we get the "real" interest rate, which is the return the holders of debt received after taking account of the annual
rise in prices.  For almost fifty years the "real" rate was very stable at about 1-2%. In the 70's – zounds  – it dropped negative for a couple of years – because inflation was running in the double digits. This meant that holders of loans (banks and trust companies for the most part) actually lost money!  1979 is the watershed.  Overnight the real rate more than triples! For those with long memories, I'm sure you remember the joy of renewing a mortgage at 12 or 13% or paying above 20% on your credit card balances in the early1980s.  These were the "nominal" rates that included inflation of close to 10% but the underlying real rate had moved to unprecedented levels.  Moreover, it has stayed on this new plateau ever since, dropping a little from the heady early Volcker rates, to be sure, but still a steady  two or three times the 1920-1970 stable level of about 1.5%.  Readers who scan the business press may have noted items that celebrate the lowering of inflation to 1960s levels. By way of contrast, mortgage rates in the 1960s were about 3%, now they're about 7%.

But this was not enough for scared capitalists. They wanted to ensure that they didn't have to put up with another debacle like the 70's.  How could they lock in the gains in their share of output, courtesy of Paul Volcker?  To understand
the strategy chosen and brilliantly executed –  deficit phobia –  we need to explore some ideas that go beyond the production function, i.e. inflation, government finance and unemployment.  Tune in tomorrow for this.

Economics for Humans, part 1: Dividing the Spoils of Production © Hector LaPaunche, 1998