[A-List] Henry C. K. Liu: OLEC - Part 3

["Sabri Oncu" <soncu@xxxxxxxxxxx>]

PART 3: Failed theories on the value of labor

Real economic progress for working-class people has been held back by a
series of dysfunctional economic theories on unemployment. 

Phillips curve. The "Phillips curve" purports to show that the annual
percentage rate of inflation consistently increases whenever the percentage
rate of unemployment decreases. The observation originated in 1958 when A W
Phillips documented a relationship between unemployment rates and changes in
wage rates in the United Kingdom, again before globalization. Other 
economists liked the idea, but not the details, and replaced wages with
prices, predicting that the unemployment rate would be negatively correlated
with the annual inflation rate, being that inflation is defined as primarily
wage-pushed. This reinvented relationship was confirmed by US economic data
for the 1950s and '60s, but was contradicted by US data for later years. 

The US economy achieved combinations of growth and inflation in recent years
that many economists thought were no longer attainable. With the
unemployment rate below most estimates of the NAIRU (non-accelerating
inflation rate of unemployment) and falling for the few years before 2000,
many Phillips curve-based forecasts predicted that inflation should be
rising. However, inflation has generally remained stable or even declined
because of globalization (cheap imports). Many observers have attributed
this anomalous behavior to special factors, such as large declines in import
prices associated with the 1997 Asian financial crisis and the appreciation
of the US dollar by default. 

Important among those imports was crude oil, whose price fell from roughly
US$23 per barrel in the fourth quarter of 1996 to just over $10 at the end
of 1998. Oil is now more than $60 and most analysts anticipate it will stay
above that level for the foreseeable future. 

Since energy prices are a component of many Phillips-curve models - the
principal tool used by economists to explain inflation - answers to these
questions could be read directly from model estimates. However, the Phillips
curve literature has largely ignored a substantial and growing body of
evidence that oil prices have asymmetric and non-linear effects on real
activity, as well as that structural instabilities exist in those
relationships. Since around 1980, oil-price changes have seemed to affect
inflation mostly through their direct share in a price index, with little or
no pass-through into core measures. By contrast, before 1980 oil shocks
contributed substantially to core inflation. The econometric evidence for
this result is highly significant and is robust to different economic
activities, oil price, and inflation measures, changes in sample coverage,
and lag specification. There are several reasons that the relationships
between oil prices and macroeconomic variables might be difficult to
identify. One is the time-series behavior of oil prices themselves. 

Okun's Law. In his original 1962 research "Potential GNP: Its Measurement
and Significance", economist Arthur M Okun (1928-80), chairman of the
Council of Economic Advisers under US president Lyndon Johson, found that a
1% decline in the unemployment rate was, on average, associated with
additional output growth of about 3%. Okun's Law is now widely accepted as
stating that a 1% decrease in the unemployment rate is associated with
additional output growth of about 2%. 

But since data from the period validating the law fell only within the range
of unemployment rates from 3% to 7.5%, Okun's Law is interpreted as not
applicable to zero unemployment. In 1993, Okun's Law would have had GDP
(gross domestic product) growth increasing substantially in the United
States, whereas it in fact fell relative to 1992. The reverse occurred in
1996: GDP growth was higher than in the prior year, despite the decline
predicted by Okun's Law. Of course Okun's Law did not take into account the
impact of globalization on growth and unemployment. 

Okun believed that wealth transfers by taxation from the relatively rich to
the relatively poor are an appropriate policy for government. By recognizing
the loss of efficiency inherent in the redistribution process, he set limits
on the benefits of redistribution. But the solution is not to take from the
rich, but to prevent more from flowing unfairly to the rich. 

Granger causality. The stock market is the score-keeping arena of
capitalism. The procedure for testing statistical causality between stock
prices and the economy is the direct "Granger causality" test proposed by C
J Granger in 1969. Granger causality may have more to do with precedence, or
prediction, than with causation in the usual sense. It suggests that while
the past can cause/predict the future, the future cannot cause/predict the
past. 

According to Granger, X is said to cause Y if the past values of X can be
used to predict Y more accurately than simply using the past values of Y
alone. In other words, if past values of X statistically improve the
prediction of Y, then we can conclude that X "Granger-causes" Y. Given the
controversy surrounding the Granger causality method, empirical results and
conclusions drawn from them should be considered suggestive rather than
absolute. This is especially important in light of the recurring "false
signals" that the stock market has generated in the past. The stock market
has traditionally been viewed as an indicator or "predictor" of the economy.
Many believe large decreases in stock prices are reflective of a future
recession, whereas large increases in stock prices suggest future economic
growth. But everyone knows stock prices do not always reflect market
fundamentals, only market participant sentiments, which is the stuff of
technical analysis. Such sentiment includes herd instinct and panic. There
is also the dynamics of overshoots and overcorrections. Yet in the age of
finance capitalism, finance dictates the fate of the real economy. 

Granger causality has been used to compare stock market prices with changes
in GDP, allowing phase correlations between the two to predict future GDP
based on prior stock-market trends. It is thus primarily a creature of
econometric models. An absurd example of statistical causality would be:
John drives to work on the highway around 8am every morning, Monday to
Friday, but not Saturday or Sunday. On exactly the same days, a torrent of
traffic hits the highway about 15 minutes after he drives on it, but not on
the days that he doesn't. Therefore there is statistical causality in that
John causes the tide of traffic to follow him 15 minutes after his passage.
That's the kind of nonsense that Granger causality can get you into.
Economists use it with great caution, as it has many hidden traps, such as
the quality of input data and ignorance or oversight of other external
causal variables. 

The traditional valuation model of stock prices suggests that stock prices
reflect expectations about the future economy, and can therefore predict the
economy with self-fulfilling dependability. The "wealth effect", former US
Federal Reserve chairman Alan Greenspan's frequent term, contends that stock
prices lead economic activity by actually causing activities in the economy,
thus is regarded as support for the stock market's predictive ability.
Critics, however, point to a number of reasons not to trust the stock market
as an indicator of future economic activity. They argue that the stock
market has previously and repeatedly generated "false signals" about the
economy and therefore should not be relied on as an economic indicator. The
1987 stock-market crash is one example in which stock prices falsely
predicted the direction of the economy before and after the crash. Instead
of reflecting continuing growth, the market hit a brick wall and the US
economy entered a recession that many expected to last a few years, though
with the Fed liquidity cure, the economy quickly recovered and continued to
grow until the early 1990s. 

Even when stock prices do precede economic activity, a question that arises
is how much lead or lag time the market should be allowed. For example, do
decreases in stock prices today signal a recession in six months, one year,
two years, or will a recession even occur? An examination of historical data
yields mixed results with respect to the stock market's predictive ability.
>From 1956-83, stock prices generally started to decline two to four quarters
before recessions began. Stock prices also began to rise in all cases before
the beginning of an economic expansion, usually about midway through the
contraction. Other studies have found evidence that does not support the
stock market as a leading economic indicator. A study indicates that between
1955 and 1986, out of 11 cases in which the Standard and Poor's Composite
Index of 500 stocks declined by more than 7% (the smallest pre-recession
decline in the S&P 500), only six were followed by recessions. Furthermore,
another study found that stock-price collapses predicted three recessions
for the years 1963, 1967 and 1978 that did not occur. 

Now, the question is: Can unemployment be eliminated through growth? The
answer seems clearly no, if unemployment is viewed in macroeconomics as a
flexible but necessary component to keep inflation low for growth. The
Phillips Curve seems to suggest that unemployment is necessary for growth.
In truth, the only cure for unemployment is to make unemployment
unacceptable, like a pandemic disease. Policymakers need to set full
employment as a goal even if it means a lower growth rate, or to assign a
heavier penalty for unemployment in the measurement of growth. In other
words, there can be no growth registered if there is unemployment. 

Zero unemployment must be the sine quo non of registering growth. By
definition, 1% unemployment must be registered as 2% negative growth, rising
on a geometric rate, with 2% unemployment registered as 4% negative growth.
Then policymakers would not be toasting themselves with champagne for their
amazing growth rates while ten of millions are still out of work. A global
cartel for labor could act as an institutional lobby for changing anti-labor
economic concepts and formulas. 

The idea of a general glut

Classical and neo-classical theories are mostly based on the simplistic,
even tautological, assertion of supply creating its own demand. Classical
economists were aware of the existence of widespread systemic unemployment,
which was later called structural unemployment by monetarists, and that
markets could and regularly did fail if unregulated. But in their quest for
universal truth at the expense of pragmatic reality, they concluded that
these were due to excess supplies and demands of particular commodities and
not excess supplies (or gluts) of commodities on a macro scale; in other
words, problems of sub-optimization caused by market inefficiency. 

But markets exist only because of sub-optimization inefficiency; otherwise,
if everyone produces only what he needs or what his neighbors would readily
absorb, there will be no surplus to trade. British classical economist David
Ricardo was supported by James Mill (1773-1836), father of John Stuart Mill
(1806-73) of On Liberty fame. A partisan of the Banking School, James Mill
also participated in the Bullionist Controversies of the time, arguing
against gold parity (see Banking Bunkum Part 1: Monetary theology, November
6, 2002). He wrote an essay that reviewed the history of the Corn Laws,
calling for the removal of all export bounties and import duties on grains
and criticizing British economist Thomas Robert Malthus for defending them. 

Mill opposed the views of William Cobbett (1763-1835), who championed
traditional rural England against the changes wrought by the Industrial
Revolution, and Thomas Spence (1750-1814), who was strongly influenced by
Tom Paine and argued that all land should be nationalized. Cobbett argued
that land (rather than industry) was the source of wealth, that there were
losses to foreign trade between nations; that the public debt was not a
burden; that taxes were productive; and that crises were caused by a general
glut of goods. A general glut is the equivalent of overcapacity in today's
global economy. 

Mill's Commerce Defended (1808) attacked all of these arguments, dismantling
them point by point. Ricardo extended this proposition to savings and
investment. If one produces more than one consumes, then the surplus is
saved and by definition traded or invested. No one would produce in excess
of consumption needs if one did not have a desire either to exchange the
products or invest its profits. Supply, therefore, creates demand. Virtually
all classical economists held this to be an irrefutable truth. James Mill's
Elements of Political Economy (1821) quickly became the leading textbook
exposition of doctrinaire Ricardian economics. 

But in a truly efficient market, only a fool will produce more than he can
consume through exchange. Markets are the composite of well-meaning fools
thinking they act in their self-interest but in fact act in their own
self-disadvantage, which they then seek to recover through the market. Thus
a general glut is unavoidable through aggregate sub-optimization. It is by
extending this mentality that Ben Bernanke, the new chairman of the US
Federal Reserve, concludes that free trade has produced a global glut of
savings, by denying that in this post-industrial age of finance capitalism,
it is demand that creates it own supply, not the other way around. And
rising demand comes only from full employment at rising wages for a growing
population. Inadequate demand creates gluts. Thus demand management is the
challenge of the post-industrial finance economy. To meet this challenge, a
global cartel for labor is necessary. 

Ricardo also suggested the impossibility of a "general glut" (an excess
supply of all goods), as overproduction in one sector results necessarily in
underproduction in other sectors, so that an aggregate general glut cannot
emerge. While this assertion is theoretically promising, it has since been
invalidated by events in recent decades when overcapacity has become the
curse of the global economy, albeit that the overcapacity in manufacturing
is actually the result of undercapacity of social services. 

Rent must be spent on worker benefits

Ironically, Malthus and the French economist J C L Simonde de Simondi, in
their belief in the inevitability of a general glut, became exceptions to
the classical economist's faith in perfect markets. They argued that income
comes as wages to workers, as profit to entrepreneurs and as rent to
landowners. Classical economics ordains that wages are consumed and profits
reinvested, but makes no stipulation as to what happens to the rent received
by landowners who presumably may choose to consume or not to consume it. As
long as profits are positive and worker income is mathematically less than
output, a general glut of goods will result even if the investment-savings
equivalence holds, if landowners fail to consume their rent in peace or
waste it on war. 

Under feudalism, before the ascendance of the bourgeoisie, rent went mostly
to building of palaces and elaborate manor estates and patronage of art and
architecture to prevent the emergence of a general glut. Malthus made the
famous argument that landlord consumption functionally increased to "fill"
the general glut, an argument that framed itself as a scientific apology for
feudalism in which the aristocracy owned the land by birthright and consumed
conspicuously, leaving behind in posterity a network of tourist attractions
in the form of grand palaces and heroic monuments. Since landlords did not
produce anything, nothing was added to output by their conspicuous
consumption, but their very unproductiveness was functionally necessary
since it maintained demand for goods and services, particularly those not
affordable by the poor, while at the same time reducing investment that
might lead to a general glut, not to mention bringing art and culture into
civilization. But if landlords should hold back consumption in peacetime, a
general glut would be unavoidable that would inevitably lead to war. 

In post-monarchal societies, the state has replaced the landowning
aristocracy, and the state must spent its rent income in the form of social
services, such as heath care, education, retirement benefits, environmental
protection and cultural subsidies, the soft monuments of civilization, to
prevent a general glut. Instead of palaces, the state must build
universities and research centers, and physical and social infrastructure.
This is the strongest economic argument for a welfare state, not
humanitarianism. To the extent wages are raised to high levels, and rent
reduced, the threat of a general glut will be reduced. Thus only high wages
with full employment can remove the regressive need for welfare-statehood,
not volunteerism in charity. A global cartel for labor, then, is the best
way to do away with the humanitarian need for a welfare state and to allow
the state to refocus on its economic role of spending rent on education,
physical and social infrastructure, and environmental preservation. 

Malthus' identification of the landlord class as functionally necessary and
beneficial stands in stark contrast to Ricardo's view of its members as
parasites. It had been the fundamental question behind the class struggle
between the land-owning aristocracy and the rising bourgeoisie that gave
rise to the French Revolution that had influenced the views of both Ricardo
and Malthus. The post-Revolution French bourgeoisie gained economic
dominance by manipulating the hungry masses against the aristocrats, yet
politically failed to achieve full control of the state apparatus. The power
struggle after the French Revolution and during the Age of Napoleon between
the landowning bourgeoisie and the rising factory-owning industrialists had
no class content, only an intra-class rivalry, as reflected in the British
Corn Law controversy (see Big money and the Corn Law, May 1, 2002), until
the industrialists won and produced a social structure of mobile capital
investing in labor productivity that led to the Revolutions of 1848, in
which the first modern class struggle ended in failed democratic
revolutions. 

The original Corn Laws in 1360 were a set of regulations restricting the
export or import of grain to keep English grain prices low, in defiance of
the Law of One Price. The purpose of the laws was to assure a stable and
sufficient supply of grain (or "corn" in British English, not just maize,
which the word refers to in North America and Australia) from domestic
sources, yet allowing for import in time of dearth. The Corn Law of 1815, in
contrast, was designed to maintain high farm prices, also in defiance of the
Law of One Price, much like today's agricultural subsidies, and to prevent
an agricultural depression after the Napoleonic Wars. Since its repeal in
1846, industrialism became the governing force in England and worldwide free
trade its policy which consolidated British control of the sea and the
spread of official British imperialism and its network of colonies that
constituted the British Empire. The Opium War in China took place in 1840. 

This development accelerated the growing consolidation of industrial
capitalism with colonialism under government protection. National income for
the imperialist countries grew, but a relatively small portion of it went to
domestic workers beyond subsistence. National wealth grew independent of
domestic wages through the exploitation of colonies. National income between
the home country and its colonies also polarized, as between those nations
with empires and those without, setting off a race to acquire colonies even
among minor European states such as the Netherlands and Belgium. The
national wealth of Britain skyrocketed, with modern factories, palatial
country estates and financial institution stocked with gold alongside slums
of the working poor. The new industrial empires were built on low wages both
domestically and overseas. 

The accumulation of capital led to a need for a regime for the export of
capital in the overseas quest for low-cost raw material and labor, as a way
of keeping domestic wages low even as general living standards rose. Workers
were then told by the Manchester School intellectuals that the income of
workers is set by ineluctable laws of economic science, that it is best and
necessary to keep wages low and that the way to a better life is to leave
the working class and to ape the employer, or eventually become a Labor Lord
through unionism. This advice was given notwithstanding that British society
at that time provided not the slightest social mobility, because of its
rigid class structure institutionalized by an education system based on
exclusionary social manners and elocution. Elaborate labor-price theories
were concocted with circular data justifying the theories, explaining
circularly those very same data as scientific truth, eventually leading to
NAIRU, a theory that argues circularly that structural unemployment is
necessary to curb inflation and that uncurbed inflation only creates more
unemployment. 

The concept of a labor market

The concept of a labor market was promoted by market liberalism as a
reigning doctrine to reinstitute a new form of slavery for the industrial
age. 

The institution of slavery is predicated on the legal treatment of humans as
property to be bought and sold. In a fundamental sense, slavery is dependent
on the rule of law in the protection of property over morality and humanity.
The growing wealth of Rome and the protection of property by Roman law led
to a sharp increase in both domestic and estate/plantation slaves whose
land-owning masters had absolute power over them. Manumission was mostly a
financial transaction. Spartacus led a slave revolt against Rome in 73 BC.
He was killed in battle and the slave revolt was suppressed within a year.
Pompey, back from the conquest of Spain, annihilated the movement,
crucifying 6,000 captured slaves along the Capua-Rome highway as a warning
for future generations. Nevertheless, the revolt served as warning to
landowners against excessive mistreatment of slaves. 

At the end of World War I, Karl Liebknecht and Rosa Luxemburg led a group of
radical German socialists to form the Spartacus Party to typify the modern
wage slave in revolt like the Roman Spartacus. Spartacists demanded the
dictatorship of the proletariat by mass action and officially transformed
themselves into the German Communist Party. On January 5, 1919, a massive
workers' demonstration was brutally suppressed and Liebnecht and Luxemburg
were arrested a few days later and murdered while in custody. 

Both Christianity and Islam accepted slavery. The manorial economy of
feudalism transformed slaves into the serfs or villeins. The Black Death
(1347) depleted the supply of labor and opened a window of freedom for
European serfs by giving them more market power. In China, Marxist
historians viewed the struggle of the emerging landlord class to replace the
slave-owning society that began in the Zhou Dynasty (1027-221 BC) part of a
revolutionary dialectic. 

In the industrial age, emancipated slaves became free agents but labor
remained a commodity, sold by the laborer and bought by the employer in a
fantasized free market, the ideal of which would be totally free labor - at
zero net cost to the employer beyond the cost of keeping the worker alive.
Thus the English language is insightful that "free" means both the ability
to choose and a state of no cost for something not quite worthless in a
price regime. Yet the value of capital is fundamentally different. 

The rent for money is interest, while the intrinsic value of money is its
purchasing power. With labor, the rent of labor is wages, while there is no
intrinsic value for labor without employment and the capitalized value of
labor is the discounted value of a worker's lifetime aggregate wage
potential. Thus humanity is denied capital value by neo-classic economics.
Yet the mobility of capital is not matched by mobility for labor, which
remains fixed in location by exclusionary immigration laws. The US was
unusual in having a welcoming immigration policy, albeit openly racist until
recently, which contributed significantly to the rapid rise of US national
wealth. 

The hourly wage serves the employer better than no-wage slavery served
slave-owners. The employer is not even obliged to pay living wages, passing
much of the cost of a decent life on to state-financed social-welfare
programs, while the slave owner had to bear the fixed cost of keeping slaves
alive and healthy for productive work. The labor market is described as
being governed by the laws of supply and demand. Employers can lay off
workers in response to business cycles caused mostly by overinvestment. Low
wages are tolerated as the neutral result of impersonal market forces, not
immorality on the part of unprincipled management or misguided government
policies. And surplus labor supply, like goods that are stored in
warehouses, are to be warehoused by poor relief to prevent social unrest.
The economic concept of a free market for labor is that it is a mechanism to
realize the lowest price for the buyer rather than the highest price for the
seller, as in a cartel, which in modern industrial enterprises is called a
union shop. The New Poor Law of 1834 in Britain safeguarded the labor market
for employers by making unemployment relief more unpleasant than
below-living-wage employment, supported with stern, self-righteous precepts
of the dismal science as set out by Ricardo and Malthus. 

Karl Marx's critique of Malthus started from a position of agreement. Marx's
idea of capitalist production, however, is characterized by his
concentration on the division of labor and his observation that goods are
produced for sale for money in a market economy and not for consumption or
barter for other goods. In other words, goods are produced simply for the
intention of transforming output into money as capital to purchase other
commodities for more investment. Thus advertising becomes the means with
which to persuade the public to buy goods they otherwise do not need or
want. The possibility of a lack of effective demand therefore is held only
in the possibility that there might be a time lag between the sale of a
product (the acquisition of money) and the purchase of another commodity
(its disbursement) to add value by labor. This possibility, also originally
crafted by Simondi in 1819, endorsed the idea that the circularity of
transactions was not always, and in fact seldom if ever, complete and
immediate. If money is held, Marx contended, even if for a little while,
there is a breakdown in the exchange process and a general glut can occur.
Moreover, in finance capitalism, which arrived after Marx's lifetime, money
does get held speculatively to produce a general glut as an opportunity to
buy cheaply for future profit. 

Marx, like Malthus, also accepted the savings-investment identification link
but reached a different conclusion. Since investment is part of aggregate
demand, circulation does continue in time even if money is held. The drive
for accumulation, Marx concluded, will continue unhindered and thus a
general glut crisis of the sort Malthus described can never happen, or if it
did, it would be practically inconsequential. What can happen, as Ricardo
originally claimed, is that a single good may be oversupplied, causing a
very temporary and small adjustment of proportions that might seem to be a
general glut but in fact is not. Thus all classical economists except
Malthus and Simondi were generally in agreement over the validity of Say's
Law, at least in the long run and under conditions of full employment. They
all also agreed on the linked identification of savings and investment, as
well as the possibility of separating output and price theory. Thus when
supply-siders promote supply-pushed economic stimulation while they accept
unemployment as structurally necessary for combating inflation, they are
walking on only one leg of Say's two-legged law. This shortcoming is
significant because as long as unemployment is viewed as necessary for sound
money, overcapacity will plague the economy. 

In 1815, Ricardo published his ground-breaking "Essay on Profits", in which
he introduced the differential theory of rent and the law of diminishing
returns to land cultivation. With wages stuck at their natural level,
Ricardo argued that rates of profit and rents were determined residually in
the agricultural sector. He then used the concept of arbitrage to claim that
agricultural profit and wage rates would be equal to their counterparts in
industrial sectors, showing that a rise in wages did not lead to higher
prices, but merely lowered profits. In his formidable 1817 treatise
Principles of Political Economy and Taxation, Ricardo articulated and
integrated a theory of value into his theory of distribution. For Ricardo,
the appropriate theory was the "labor-embodied theory of value" (LETV), ie,
the argument that the relative "natural" prices of commodities are
determined by the relative hours of labor expended in their production at
the natural price of labor. 

With prices pinned down by the LETV, Ricardo restated his original theory of
distribution. Dividing the economy into landowners (who spend their rental
income on luxuries or wars), workers (who spend their wage income on
subsistence necessities) and capitalists (who save most of their profit
income and reinvest it), Ricardo argued how the size of profits is
determined residually by the extent of cultivation on land and the
historically given real wage. He then added on a theory of growth.
Specifically, with profits determined by the gap of market price over
natural price, the amount of capitalist saving, accumulation and labor
demand, growth could also be deduced. This, in turn, would increase
population and thus bring more land of less and less quality into
cultivation and use, such as the founding of colonies overseas or desert
cities such as Los Angles and Las Vegas. Moreover, mechanization and
innovation improve the yield from land and release labor from the
agriculture sector into the industrial sector, which pays higher wages,
generating more demand and economic growth. 

Ricardo did not anticipate the emergence of finance capitalism, in which
labor from industry would be released into service sectors, and growth can
be driven by financial engineering. Still, wealth cannot be detached from
human capital. If the value of labor expressed as wages is kept low, growth
can only come as financial bubbles. For this reason, a global cartel for
labor is the solution to the current debt bubble in the global economy. 

Tomorrow: Toward living wages in the modern era 

Henry C K Liu is chairman of a New York-based private investment group. His
website is at http://www.henryckliu.com.