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!
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