Sunday, October 26, 2014

"Cake without Flour" -- Duncan Foley on the Dilemmas of Economic Growth

The following excerpt is from Duncan Foley's outgoing Presidential Address to the Eastern Economics Association, "Dilemmas of Economic Growth," presented March 9, 2012 (Reprinted by permission from Macmillan Publishers Ltd: Eastern Economic Journal (2012) 38, 283–295 published by Palgrave Macmillan). The title is an allusion to Herman Daly's parody of Cobb-Douglas production function hyperbole "as implying that it is possible to bake a cake without eggs or flour as long as the cook whisks the empty bowl faster and faster."


Some growth economists might regard the considerations we have just reviewed as rather quaintly anachronistic in putting so much emphasis on the material nature of economic production. Well-established patterns of economic growth show that as incomes rise, the proportion of output as measured by such indexes as real GDP consisting of material goods steadily declines. The major sources of growth in incomes (and, given the way we measure GDP, in indexes of output) shift to the tertiary sector, particularly services. The chief input to services is human intelligence, and at least in some accounts, intelligence is an unlimited resource. So why couldn't real GDP, measured to include the use-value of services, continue to grow without limit?

There are some immediate problems with this conception. Strictly speaking the production of almost all services does require material and energy inputs, as the gigantic server farms required for information technology are a concrete reminder. Maintaining the human capital to provide a glittering array of intellectual services requires material and energy inputs, and these very likely increase as the quality of intellectual output rises.

But this vision of endless growth without material or energy inputs requires some re-examination of just what it is that we regard as output and try to measure in indexes like real GDP. Some rapidly growing service industries, such as finance, seem to be able to produce increasing measured output without much input increase, even of human employment, at all [Basu and Foley 2011; Foley 2011]. An examination of the issues raised by the growing significance of service industries, which have no measurable output, raises some deep questions about the conception of economics.

The paradigmatic economic interaction for economic theories rooted in the marginalist revolution, such as neoclassical economics and its various descendants, is a transaction in which one good moves from the possession of an agent who subjectively values it less to the possession of another agent who values it more, in exchange for another good (in many transactions money). As the familiar Edgeworth-Bowley box construction illustrates, this type of transaction puts both agents on a higher (or at least no lower) indifference curve, and thus achieves a Pareto-improvement in the allocation of existing resources. Many financial transactions are of this type, for example, initial public offerings to take companies public, real estate brokerage, insurance contracts, and other more exotic forms of financial arbitrage. It is important to remember, however, that the transfer of existing goods or assets in these transactions is not production. When financial intermediaries appropriate some part of the economic surpluses generated in these transactions as revenue, however, economic statisticians have felt compelled to regard the resulting incomes as part of national income, and to invent an imaginary product, financial services, to put on the product side of the accounts as a counterpart.

It is hard to imagine limits to the magnitude of subjective economic surpluses that could be realized through transactions of this type. If, for example, policies or the historical evolution of the division of labor increase economic insecurity by eroding the institutions of traditional societies, one can easily imagine an unlimited expansion of insurance transactions as a result. But from the point of view of classical political economy, it is the increase in material productivity of labor, not the increase in economic insecurity associated with the expansion of the division of labor, which is the source of improvements in economic welfare. This point of view is deeply embedded in the methods of national income accounting, for example, in the fundamental rule that transactions involving the transfer of existing assets do not constitute production of goods and services, no matter how much economic surplus they may represent.

The classical political economists and Marx addressed these issues through the concepts of "productive" and "unproductive" labor. In the version of this distinction, Marx distilled from his critical review of Adam Smith, productive labor (whether it produces material goods or services, since providing haircuts is hard to distinguish from making hats) returns the costs of production with a profit, while the cost of unproductive labor is paid out of revenues without any recovery or return. This classical-Marxian line of thinking puts the origin of the incomes from the production of "services," such as finance, in a different perspective.

This perspective is perhaps most clearly articulated in Marx's analysis of wage labor and the origins of surplus value. Productive labor is responsible for the whole value added in production, but receives only a fraction of the value added in the form of the wage. The resulting surplus value constitutes a pool of potential revenue for which capitalist producers, landowners, intellectual property owners, financial firms controlling money capital, and the state compete. The implications of this analysis, which, unfortunately, is for the most part systematically excluded from the modern economics curriculum, are far-reaching. No particular capitalist firm, no matter how large in revenue and employment, can have much direct effect in increasing the pool of surplus value. Thus "money-making" in capitalist society is proximately based on taking surplus value away from others. In an economy where resources and intellectual property command enormous rents, there may be a vanishingly small connection between the revenue of any entity and its actual contribution to production of useful output.

Many people today are dazzled by the apparently magical ability of innovators to appropriate enormous revenues on the basis of ideas and their manipulation alone. This phenomenon has understandably spawned theories of a "new" economy, supposedly based on new principles of the creation of value. Classical-Marxist political economy, in contrast, locates incomes to innovation not in new principles of the creation of value, but in new (or newly important, since most of these "business models" have actually been around for a long time) modes of appropriation of surplus value. As Slavoj Žižek vividly points out, increasing returns in the appropriation of rents for intellectual property simultaneously obscure the origin of the resulting enormous incomes in the pool of surplus value appropriated from productive labor and mystify the factors behind the increasing inequality in the distribution of these revenues [Žižek 2012]. The origin of the rent of a particularly exploitable resource like a waterfall or a petroleum deposit is hard enough to understand, but at least the owner of a waterfall cannot allow an unlimited number of cotton mills to exploit the resulting usable energy. By contrast, the owner of the rights to distribute a piece of software that, due to network externalities, becomes a technical standard, can allow an effectively unlimited number of users to install the software and charge each of them a fee.

It would be, however, a peculiar political economy that convinced itself that the increasing returns in the rents to artificially created assets, such as systems software, were a remedy for thermodynamically imposed decreasing returns to resource use in material production.


Anonymous said...

Thanks for finding and posting this as it shows that at least to some degree some people still acknowledge that (nominal) GDP is an index, and should be accounted of (gross) value added, and that it being gross of depreciation (and sometimes of inputs) will result in asset stripping being mistaken for production, even if that is a different order of argument.

Mentioning "Marx" in any argument of course in the current climate means making it less academically and politically "respectable", so that's unfortunate.

Because the debate about GDP, nominal GDP, and hedonics/use value accounting can also be based on "traditional capitalist" notions of solid and proper accounting rules.

Sure, grifters and shysters and "sell side" professionals and Economists hate solid and proper accounting rules even more than they hate Marx, but there is I think a bigger constituency for arguments mentioning them than Marx.

Anonymous said...

However the author of the speech seems deeply confused about what production is and that GDP is defined properly as final production net of inputs and not just gross of depreciation (positive or negative).

This bit in particular is absurd:

«An examination of the issues raised by the growing significance of service industries, which have no measurable output,»

Because *all* service industries have measurable outputs, such as tons-miles hauled for goods transportation, hamburgers-prepared for fastfood, advice-hours-delivered for consultants. Two hours of watching a movie in a movie theater is both as measurable and production as the recording of the same movie on DVD or the streaming of the same over the Internet.

Some of them are close to tangible, and some of them are quite intangible; some of them are final production and some of them intermediate services.

But in general service industry (gross) output is indeed measurable, even when intangible.

Even when the *value added* in that gross output is difficult to define, and even when it is intermediate and should be subtracted instead of added to GDP.

So as to «initial public offerings to take companies public, real estate brokerage, insurance contracts» is not merely the case that «financial intermediaries appropriate some part of the economic surpluses generated in these transactions as revenue» because conceivably there is a lot of in carrying out the work of IPOs, conveyancing, managing insurance, and (some) people are prepared to pay for that just as they are prepared to pay for getting drunk in bars or for smoking cigars. Those are all legitimate forms of actual production.

What is arguably very different is that most "financial services" (which can measured as numbers of IPO, houses, contracts processed) are not final production.

Train companies don't buy financial services because they enjoy them, but purely as a *cost* of doing business...

Peter Dorman said...

Blissex took the words right out of my fingers. The core problem with the growth of services is that this sector provides an intermediate good. We have massive double-counting disguised as growth.

Aside from this, Duncan Foley overlooks the increasing role of skill and knowledge inputs into the value of material products -- the service component of the goods sector. What is the difference between an appropriately priced $20 bottle of wine and two buck chuck? Ultimately it's about the skill (and time) that knowledgeable growers and vintners put into the better product. Physically, we're still talking about land and vines and presses and casks, but everything else is a service contribution. (Land rents play a negligible role at this price level but, yes, are important for higher end wines. You can make drinkable wine on the same land that TJ's gets its plonk from.)

Finally, I'll be more impressed by claims that the second law of thermodynamics is dictating economic outcomes when I see some careful empirical evidence. The issue is not whether thermodynamics is a constraint -- of course it is -- but whether it is observably a binding constraint.

Sandwichman said...

"An examination of the issues raised by the growing significance of service industries, which have no measurable output, [input?] raises some deep questions about the conception of economics."

From context, I would suggest that Foley meant to say input where he said output. I read Blissex's criticism of this point to be contrary to what Peter wanted to say.

Peter, presumably the knowledgeable growers and vintners would like to get paid for the skill and time they put into making the better product. What they do with their income is up to them but on average they're going to buy the same average bundle of goods that people making their level of income consume. The 10 times quality improvement quickly dwindles to the standard .3 increment (especially when those container ships loaded $12 a bottle Argentinian Malbec slow steam into harbour).

Empirical evidence? You want "empirical evidence" that something will not happen in the future which has never happened in the past?

Sorry, I have no "empirical evidence" from the future. Do you?

There is, however, ample empirical evidence that absolute decoupling of GDP growth from material inputs has never happened on a global scale and sustained absolute decoupling has never happened at a country level. ("Green goals and full employment: Are they compatible?" Miklós Antal, Ecological Economics 107 (2014) 276–286).

Sandwichman said...

By the way, I agree entirely with Peter's statement that "we have massive double-counting disguised as growth." That accords with what Kuznet argued in the 1940s, with what Tinbergen and Hueting have shown about asymmetric accounting and with Bartolini's analysis of negative externality driven growth. It's also consonant with Fred Hirsch's Social Limits to Growth argument.

Imagine, though, that the labor-leisure choice model was true and people could choose to take their increased productivity in the form of leisure. And imagine that the increases in GDP over the last half century were actual and that the proceeds were fairly equitably distributed.

Sandwichman said...

Blissex: "Mentioning "Marx" in any argument of course in the current climate means making it less academically and politically "respectable"..."

The objection these days to Marx is mainly to his use of "solid and proper accounting rules".

I avoid referring to Marx beyond the odd literary allusion. Much the same points can be made with reference to John Maurice Clark or T.W. Hutchison and they will be studiously ignored, side-stepped, misrepresented or scoffed at by capital "E" Economists.

Greg said...

Peter's discussion is a micro-economic one and therefore unsuitable for reasoning about the whole economy.

Imagine an economy with two goods, lettuces and wine. Badly made wine is initially exchanged for badly grown lettuces at par, i.e. one bottle for one lettuce. Everyone consumes one of each a day (no-one's going to want more than that.)

We pump in some human capital (tm) and allow time for it to diffuse throughout the economy.

We now have excellent wine being exchanged for excellent lettuces ... at par. Everyone still consumes one of each per day (but they enjoy them a lot more).

So what does the human capital do, again?