Value subtracting

I gave my presentation yesterday on “Classical Criticisms of Modern Economic Theory”. I might also have called it “The Top Ten Reasons Why Modern Economics is Useless in Understanding How an Economy Works”. Therefore, at the rate of four minutes per reason, not very likely to persuade anyone who doesn’t already have an inclination to abandon modern textbook theory. But there was one issue that remains at the core of the classical perspective that met with resistance. I treat it as obvious beyond needing to elaborate, but it may be more difficult than I think.

Modern economic theory is based on the belief that increases in demand drive the economy forward. The Classicals were all supply-siders with immense disdain for the notion that demand has anything to do with aggregate output or the level of employment. And central to their theory of growth was that the sum total of all economic activity had to be value adding if the economy were to increase its ability to produce. Most forms of production – consumer goods, government welfare expenditures, loss-making businesses, non-productive forms of public expenditure – are not value adding. They draw down on the economy’s resource base but add nothing back. Only those investments – both public and private – that add to the economy’s ability to produce lead to a higher standard of living.

Value subtraction does not mean zero value has been created. It means less value has been created than had been used up. If a project provides output worth a billion dollars once it’s built it is still only value adding if the value of resources used up were less than a billion. You cannot make an economy grow by promoting loss-making projects.

My examples were pink batts, school halls and the NBN. I could have added solar panels and wind farms. Does anyone doubt these make us less wealthy as a nation? Do economists?

If you want to know why real incomes in Australia are falling, understanding the role of non-value government spending is a very good place to start.

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26 Responses to Value subtracting

  1. v_maet

    The problem is that government doesn’t care about whether projects are able to add value to the economy.

    Take for example the Toowoomba Range Rail Tunnel Lowering project which is going to cost close to $50 million in capital and will never be able to recover anywhere near that amount, even if you use the maximum increase in usage assumption which would never happen because even with the upgrade road freight is more cost competitive.

    What would be a better option is to allow the market to provide truck transport as it is privately operated and competitively priced and is much better at innovating solutions, but they would rather be seen as fixing a problem rather than actually fixing the problem and using taxpayer funds effectively.

  2. Fulcrum

    I think you could add to the list desalination plants, you know the ludicously expensive monumemts celebrating the folly in alledged sustainabiliy.

  3. stackja

    Kev 07 gave us wasteful spending and Flannery.

  4. Rob MW

    The welfare system definitely value adds, just think of it this, without the system that creates subsidized couch sitting in preference to a whingeable job, these broad arsed days of our lives, or one arm bandit addicts would have to be employed. The economical value added in not employing them is immeasurable./sarc

  5. Roger

    Steve,

    What is the affect on the economy of encouraging so much personal investment to go into housing (both primary residences and second homes and rental investment properties?

  6. Warty

    Being entirely ‘literary’ minded, you’ve managed to achieve the almost miraculous: I fully understood. The study of economics, if it extends beyond five hundred words, sends me cross-eyed.

  7. A H

    Hi, I was there for the talk. Sorry, I wasn’t able to stick around afterwards.

    Was that the objective of the talk, to persuade people to abandon modern accepted theory?

    The triangle that was the centre of the talk is a good, succinct way of showing that the ability to consume is determined by investment, and that increasing consumption without investment will reduce the ability to consume in the long run.

    I think these sorts of abstract models don’t appeal to most people though. It takes some reflection to understand what they mean.

    I also don’t believe that politicians care about economic theory. They are essentially con artists by trade and I don’t see that they could acknowledge being disproven. As someone pointed out yesterday, politicians will assure you that their vote-buying exercises are indeed investment.

    I did have one question for you. Does classical economics disagree with the Austrian school of economics, if so, what are the points of contention?

  8. RobK

    In WA quite a number of pastoral leases have been returned to the Crown, the stock watering dams and infrastructure bulldozed and the management of the land is left to a department that has proven it’s inability to manage. The change in management system has seen many types of wildlife suffer as the landscape supposedly returns to pre-improved regimes. That’s value subtracting- at the altar of environmentalism.

  9. Bear Necessities

    To me from an Economic and Cultural perspective Investment in Public Schools should be included as well. There is no reason for any Government to own, fund or run schools. For the amount of money they receive compared to private schools the service provided is chalk and cheese. Public schools are run for the benefit of teachers and education leeches.

  10. Tezza

    I’m on board with your broad theme, Steve, but why do you list the production of consumer goods as not value adding? If consumers pay for the inputs used in production of their final consumption goods (including at least a normal return on the capital employed), their consumption choices in a reasonably efficient market are presumably somewhat value adding, if they sufficiently remunerate the producers to keep them from switching to their next best alternative production. And then there is the consumer surplus enjoyed by the infra-marginal consumers of those goods, which is also part of the value added by resources devoted to production of final consumption goods.

  11. closeapproximation

    Broadly agree. You put it in simple clear terms that are easy to understand.

    Actually, I believe that everyone has an intuitive understanding of these points. Put people on a desert island and they will act accordingly.

    But because many people’s everyday activities have some (many?) degrees of separation from these fundamentals due to labour specialisation and trends towards service economies and welfare statism, this intuitive insight gets quickly lost. But degrees of separation does not negate dependence on the fundamentals, ever-present.

    It doesn’t help that economist are witch doctors who are happy to bamboozle themselves and others with stupid models and MMT. A good example of labour specialisation *not* adding value !

    I would one point, Steve. In some cases, the value add does not materialise or become apparent until much later (decades, hundreds of years … ?). Think Fourier Transforms for comms or number theory for encryption. Having said that, your list of examples of non-value add activities are obvious and predictably bad from the outset.

  12. .

    How many of you have read Ludwig von Mises?

  13. Bruce of Newcastle

    I could have added solar panels and wind farms.

    To be fair solar panels and wind farms are more like Buddhist prayer wheels and flags. Religious structures. Which makes us a theocracy since otherwise the taxpayer wouldn’t have to pay for them. We don’t subsidise the construction of churches or mosques – those particular believers pay for them.

  14. Irreversible

    Kates: you remind me of the Irish politician who, when confronted, asked “well, it might be fine in practice, but will it work in theory?”
    In business, when a manager is said to suggest that some thing ought to be built “and they (customers) will come” it is usually the precursor to a sacking.

  15. Sinclair Davidson

    Does classical economics disagree with the Austrian school of economics, if so, what are the points of contention?

    Yes.

    The Austrian School is a branch of neoclassical economics that began with the marginal revolution in the 1870s. It differs from the the other two strands of neoclassical economics – but that only became apparent in the 1930s after the socialist calculation debate.

    The major problem with the classical school is a deficiency in the theory of value. While I know Steve will disagree – the problems with pre-1870 value theory give rise to nonsense like “rent” – and that is a huge problem.

    Having said that I agree with Steve that the Keynesian revolution was not a positive advance for the discipline, and the excessive mathematisation after the Second World War was a huge mistake.

  16. John Constantine

    The Murray Darling Basin Clearances.

    The highland clearance mentality aimed by penny ying-yen wong at non-gay non-diverse productive agricultural communities.

    Not seen as value subtracting when it tears down the obsolete racist economy of old Australia to enrich the transnational League of Looting Despots.

    Only the crony leftist insider economy counts to the apparatchiks of Australias corruptocracy.

  17. Montgomery

    Why consumer goods?

  18. max

    there no such thing as public money, only taxpayers money.
    there is no such thing as government value added investment.

    $2 Million Bathroom

  19. Ray

    It is a sad state of affairs when we think it is sufficient to misrepresent those with whom we disagree and then attempt to tear down their arguments with a lie. Unfortunately, this is what Kates is doing here.

    Modern economic theory is not based upon the belief that increases in demand drive the economy. Instead, the general consensus in orthodox growth theory is that technological innovation is the dominant factor influencing long term growth. Indeed, the two dominant strands of growth theory, Schumpeterian and semi-endogenous, disagree only on the mechanisms by which innovation influences the growing economy, creative destruction in the case of the former and exogenous shocks for the latter.

    Orthodox economics does not contend that demand drives economic growth. What it does suggest is that there are short run nominal rigidities which prevent the economy from clearing and that the management of demand is a tool which can be employed to overcome these.

    There is no doubt that wage and price stickiness prevent the economy from operating at equilibrium. There is also no doubt that monetary and fiscal policy settings can be employed to smooth the effect of these short run rigidities. However, the question which needs to be addressed is the impact of short term monetary and fiscal tools upon long run growth. In other words, what influence do expansionary monetary and fiscal strategies have upon the take up of innovation in the economy.

    Whilst economics generally accepts that taxation, regulation budget deficits and monetary intervention all have long term costs to the economy, growth economists are yet to quantify this relationship. As a result, there is still a significant body of thought which believes that there are net benefits flowing from the management of short run nominal rigidities and hence the ongoing popularity of AD/AS models.

    None of this suggests that modern economics believes demand drives the economy and such a misrepresentation is an oversimplification of a very complex issue. There remain many gaps in our understanding of the economy and we should be working to fill as many of those gaps as possible rather than devolving into an ideologically driven argument which is not supported by the facts.

  20. Troy

    Ray’s comment just highlights the point: macroeconomics suggests nothing about individual action. It is scarcity for individuals that presents existing and perennial insufficient demand. Kates, it seems to me, is addressing the so-called neokeynesian strand of macroeconomics (and in the duality of neokeynesian and neoclassical macroeconomics lies another difficulty).

    The entrepreneur solves the consumer’s problem when s/he provides a good or service as a solution. Both the producer and consumer gain profit in that exchange – monetary and psychic, respectively. If you wish, you can refer to this as individual equilibrium, but the abstract idea of market or general equilibrium is an irrelevant concept that has nothing to do with the harmony of interests, the result of mutually agreed exchange. Hence, Mises’ point that value-added exchange occurs when both parties gain.

    To Kates’ point, in a temporal, logical order, the consumer cannot consume until the producer has produced. No government committee (or economics’ faculty) provided the innovative ideas that resulted in Jobs and Apple launching the Ipad, which was about three or four (value-added) innovative steps ahead of the rest – computability, portability, as well as email and internet via wi-fi and mobile-phone, all in a neat hand-held package. And the consumers lined up in their droves at the Apple stores prior to launch. Brilliant!

  21. Rococo Liberal

    Some chappy explained it all to me recently. He said that all the money the government spent came back to it in taxes as a result of the stimulation of demand
    He refused to believe that welfare recipients don’t pay tax and that the ”tax” paid by public servants is an accounting entry. He claims he is an economist. That is the sort of person you’re fighting, Prof K

  22. Haidee

    Agree that this is put in simple terms, but don’t agree with clearapproximation 3.28pm –
    that “everyone has an intuitive understanding of these points”.
    Witch doctors, yes

  23. Louis Hissink

    The other issue is the widespread belief that an economic good’s price is an intrinsic measure of some property of the good, like mass is a property of an object. Except mass does not change over time, and hence we can, in the physical sciences, calculate where an object might be along an orbit.

    But plotting price versus time, fitting a linear regression to it and then forecasting a future price is actually no different to asserting that the price of a carton of eggs, for example, is dependent on where that box of eggs is along the Earth’s orbit around the sun. This is what the economists did when they appropriated the calculus of the physical sciences to make the social science of economics appear more scientific by being, speciously, numerate. It’s the basis for central planning, and all because of the belief that price is an intrinsic measure of a good’s value.

    This is the essential difference between the Austrians and the others.

    And I have no idea how to change this mindset, assuming I have that right in the first place, which I don’t.

  24. Ray

    Troy, modern macro-economics is all about individual decisions. That may be difficult for many to comprehend given that we look at entire markets, talk of aggregate demand / supply and engage in theoretical discussions of representative firms and representative consumers. However, equilibrium in markets is not about averages or representative firms and individuals, it is about the decisions of the marginal supplier and the marginal consumer. In other words, economics tries to identify the last consumer who would be prepared to buy at a particular price and the last firm which would produce at a particular price, at a certain time and under certain conditions.

    The point at which the marginal consumer and the marginal producer agree to an exchange is the point where a market clears. At that point, no consumer willing to buy at that price is left unsated and no producer willing to sell at that price remains.

    The question we need to ask here is not what macroeconomics suggests about the actions of individuals but how accurately economists can identify the marginal producer and the marginal consumer. Clearly, economics gets this very wrong in some instance and very right in others, but for the most the data is sufficient to make inferences about behaviour within a population.

    It is important to understand that a good economist will understand the limitations of his theory and his data and interpret his findings accordingly.

  25. max

    Microeconomics: The study of who has the money and how I can get my hands on it.
    Macroeconomics: The study of which government agency has the gun, and how we can get our hands on it.
    Gary North
    Democratic capitalism: A cooperative enterprise to earn enough money to buy enough Congressional influence to gain control over the government’s guns so as to get even more money for your special-interest group.

    Social democratic capitalism: A cooperative enterprise to promise sufficient government benefits to enough voters to gain control over the government’s guns so as to keep any other special-interest group from getting as much power as yours.
    Gary North

    The underlying premise of macroeconomics is that we can trust the abilities of Congressmen to pass legislation which tenured bureaucrats can and will administer fairly
    Gary North
    From now on, when you think “macroeconomics,” think, “I’m from the government, and I’m here to help you.”
    Gary North

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