[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.
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