Last week I argued why an objective theory of value, such as the labor theory of value used in classical political economy, is useful for understanding the value of producible goods and services. However, many valuable things are not produced and therefore lack an objective value defined by the cost of production. This week, I will discuss how people and capital are valued. Next week, I will focus more on land and natural resources.
People are not manufactured. Whether they participate in the economy as workers, capitalists, managers, or merely consumers, people are not themselves mere products. In some of its models, classical political economy (including Marx) tried to stylize workers as a mere input of the production process, an input whose cost is regulated by the cost of the means that sustain the lives of the workers and perhaps their families as well. Yet from Adam Smith on, classical political economy also considers wage levels as a product of political struggle between more or less organized capitalists and workers. In other words, the distribution of the social product between wages and profits is not determined solely by economic factors. It involves contending private powers.
Capitalists as people are even less well specified in classical value theory. They merely capture the surplus of the production process after all other costs of production are paid. There is some effort to argue that in a competitive economy, the earnings of capitalists ought to approximate the average rate of return on the capital they commit, but in general this idealization can never pertain in real economies, not least because capitalists operate with widely varying amounts of credit. At the extreme, it is quite possible for a capitalist to advance no capital at all, to rely entirely on borrowed funds, and still extract surplus. The rate of profit in this case in undefined because this involves dividing by zero. Real economies have never exhibited competitive processes vigorous enough to equalize the rate of profit across alternative uses, though textbooks have long been telling mythical stories that suggest this is what happens. Instead, private power and strategy interfere in the distribution of profits.
In general, bulls increase their profits by minimizing commitment of their own capital and maximizing employment of borrowed funds. Profit on one’s own capital is boosted, but at the risk of magnified losses if conditions change so that earnings fall or the cost of borrowed funds rise, or both. Thus most leveraged bulls make great gains during booms but are the first bankrupted when a crisis hits. Bears, conversely, borrow less aggressively or not at all and consequently grow slower and profit less than bulls do during a boom. On the other hand, when a crash hits, bears have capital reserves to purchase the discounted assets of bankrupted bulls.
The very existence of rival bear and bull strategies precludes competitive equalization of profit rates. Profits are distributed according to the outcome of interacting strategies, not according to any law of dull grey averages. Not only neoclassical economy, but even classical political economy, including Marx, get this wrong, which is why neither tradition has an adequate theory of the business cycle. Investment is strategy driven and inherently unstable. Modeling it as the average result of competitive processes utterly negates its interactive and strategic nature.
As I have often discussed in this blog, bears and bulls create, to some extent, self-fulfilling prophecies through their own action. Bulls borrow heavily to buy assets. If all assets were produced within the economy, then the expansion of credit might simply cause more and more to be produced. However, all production sooner or later runs up against bottlenecks of true scarcity. Those bottlenecks include time, since expansion of production may take time to implement, limits of available labor supply, and scarce natural resources. If bullish credit-fueled demand increases faster than output, then typically prices will rise, which is fine for the bullish owner or producer of those assets. As long as prices rise, bulls can easily finance expanded production or acquisition of assets, leading to a virtuous circle of rising credit pushing up prices and thereby securing the next round of purchases using even more credit. This ballooning credit is secured by the ever rising value of the assets.
Enter the bear. Creditors, especially owners of bonds and fixed-interest loans, do not like inflating prices because the inverse of rising prices is the falling value of money and of all debts denominated in that currency unit. The faster a credit-fueled boom expands, the more it raises prices and thus lowers the value of money and money-denominated assets. At some point in the boom, creditors may begin to react to the erosion of the value of their debt assets by price inflation. They become less willing to issue new debt or charge a higher price (interest rate) for it. As the cost of credit rises and availability tightens, asset prices stop rising. The most leveraged bulls recognize their vulnerability and start to liquidate assets to pay off loans on assets no longer rising fast enough to justify the cost of debt. This selling pressure may create a vicious circle of falling prices and more panic selling by leveraged bulls increasingly desperate to cover their loans. This is the self-fulfilling prophecy of the bears. Such reversals can happen spontaneously, but because large financial interests are highly concentrated and well organized in syndicates or consortia, they can also be coordinated among a cabal of bears. Coordinated credit tightening is bound to induce bearish declines of most asset prices.
This entire process is dynamic and strategic. It owes nothing to the equilibrium theory of neoclassical economy. There is no stable equilibrium, only a shifting balance of power between contending bears and bulls, as John Maynard Keynes describes in one section of his Treatise on Money. This sort of strategic perspective on capital values is also missing from classical political economy. Although many practical investors are quite aware of the basics of debt and leverage, of bear and bull positions, economic textbooks do not teach the consequences of the dynamic valuation of capital. If they did, then it would be impossible to argue that capitalist economies are inherently stable. Given the powerful influence of credit on prices and on private power and strategy, boom and bust cycles are a necessary consequence. Financial regulation, especially during the period from the 1930s through the 1970s, can somewhat mitigate severity of business cycles, but never entirely eliminate them in any credit-driven economy.
Since the value of capital assets is not reducible to physical costs of production, this might seem to jeopardize an objective theory of value. Yet it does not, because the expansion and contraction of credit are also objective things. My argument does suggest that a simple labor theory of value is too abstract to be of much practical use, since credit conditions so strongly influence the value of everything, including money itself.
Originally posted on World Policy Institute blog on March 31, 2016 – Valuing Capital.