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How to Understand the Economy

Educated friends who have never studied economics themselves often ask the economist Duncan Foley to recommend a book that will explain what economics is about. He doesnot find it easy, sees correctly that the standard seven-hundred-page elementary textbook is essentially unreadable, and usually ends up by suggesting the late Robert Heilbroner’s 1953 classic The Worldly Philosophers, not a bad choice. But he feels the urge to try his own hand at it, and teaches a course for nonspecialists at Barnard College and the New School University. Adam’s Fallacy is the result.

Like Heilbroner’s book, it proceeds through the standard list of Great Economists, beginning with Adam Smith, T.R. Malthus, David Ricardo, and Karl Marx. That is one possible device, but the mere history does not reveal by itself what Foley thinks the curious educated reader should know. The tip-off is the subtitle: the book is a guide to “economic theology.” I don’t like that word: theology is about God, and God does not play any role in these pages. I understand Foley’s reluctance to say “ideology,” because controversy has left so many layers of meaning on that word. It is clear anyway that he is interested in big, general themes, especially about capitalism, and not in nitty-gritty like the price of beer or the balance of trade.

There is an alternative view of the content of economics. I once wrote a brief comment on Heilbroner’s book and entitled it “Even a Worldly Philosopher Needs a Good Mechanic.” Any capitalist economy is full of “mechanisms,” compounded out of natural and technological facts, legal rules, individual motives and behavior patterns, social norms, historically contingent institutions, and the like, that together have a lot to do with the price of beer, the balance of payments, the degree of wage inequality, and so on. These mechanisms may differ from one capitalist economy to another, and will certainly differ between any feudal economy and any capitalist one. The job of economics, in my view, is to figure out how these mechanisms work, and maybe how they could be made to work better, or at least differently. The educated reader needs to understand how economists try to achieve that understanding. There is little or nothing about “how things work” in Adam’s Fallacy.

The split between “theology” and “mechanics” is much more than an expository preference; it is a determining substantive choice. Here is an illustration of the difference in approach implied by the choice. The beginning of the book—in fact the first two thirds, which is itself indicative—takes up the ideas of Smith, Ricardo, and Marx. The “labor theory of value” figures very prominently in their work and in Foley’s discussion. It claims that the “value” of a produced commodity is the cumulative amount of labor (of average skill, say) directly and indirectly required to produce it. There are many possible subtleties here, but we can ignore them. I put “value” in quotation marks because this is actually a definition; the “value” of a bottle of beer is not something you could look up in a catalog.

Adam Smith and some of the classical economists thought of this value as the “natural price” of a commodity, and expected that the actual market price of, say, a bottle of beer might fluctuate above and below, but over time would average out to, its labor-value. Ricardo eventually had his doubts about this proposition and Marx probably did not accept it at all. In any case, in actual fact prices in a modern economy do not approximate labor values, not even in any average sense. In a modern economy, wages and salaries, including fringe benefits, add up to more than twice the sum of interest, rent, and profits, so labor costs must be the most important component of prices. But that empirical statement is not nearly the same thing as the labor theory of value.

Modern economics dispenses with the notion of “value” altogether, and deals only with ordinary, observable market price. The object of the exercise is to understand why the prices of commodities (and the quantities produced, bought, and sold at those prices) are what they are, and why they change.

The modern notion of “equilibrium” price and quantity does some of the duty of “natural price” (but not of value). A market is in equilibrium when supply and demand are in balance and there are no internal forces inducing participants and potential participants to change their behavior and thus cause prices and quantities to change. For example, the equilibrium price of a bottle of beer must cover production and marketing costs as well as yield the going rate of profit, and it must attract just enough buyers to keep current capacity in adequate use. “External” forces, like population growth and the invention of new commodities and new methods of producing old commodities, are forever disturbing preexisting equilibrium prices and quantities, and this process is forever causing observed prices to deviate, at least for a while, from equilibrium. In the beer industry, the invention of a new, cheaper process of fermenting would normally force a general reduction in price, the exact amount depending on how many more customers will buy beer at the lower price. The price may fluctuate until the equilibrium level is found. Foley would say, and I would firmly agree with him, that many modern economists tend to slide too easily into the tacit presumption that deviations from equilibrium prices and quantities are almost always small and transient. This is just an error; and it may become a “theological” error, because an atomistically competitive economy in equilibrium is known to have some desirable properties that disequilibrium nullifies. So excessive optimism about equilibrium can translate into apologetics for current institutions and practices. It often does.

Suppose, for example, the demand for summer rentals diminishes, because of expected bad weather or high gasoline prices. It may take a long time before rents fall correspondingly. In the meantime, there are many vacancies, and prolonged disequilibrium. Some devotees of neoclassical (“marginalist”) economics presume that competition will almost always be sufficient to bring rents down promptly. “Marginalism” refers to the principle that market equilibrium is achieved when no agent—buyer or seller—can find any small—i.e., marginal—change in behavior that improves his or her situation, at a set of prices that balances supply and demand in the market as a whole. As Foley puts it,

Where classical political economy conceives of equilibrium as the averaging out of ceaseless fluctuations, marginalism sees equilibrium as actually being attained or approximated in reality.

A moment ago I described population growth as an external force acting on the market system. From the Malthusian point of view, population growth is an internal—the jargon word is “endogenous”—force. Malthus believed that a rise in wages or a reduction in the price of food would lead directly to faster growth of population. In turn this would cause wages to fall or food prices to rise until poverty and disease brought population back to equilibrium and real wages back to subsistence level. For that matter, some aspects of technological change are also endogenous. For example, a perceived opportunity to make a high profit will induce industrial researchers to seek and find new products and processes and bring them to market, where again prices and quantities will have to adjust.

One of the ways that economics makes progress is by trying to extend its scope, converting what had been treated as “exogenous” into part and parcel of economic theory, by which more and more can be explained. Marxism in particular has ambitions to be a sort of universal social science. Many mainstream economists also work in their own way at absorbing family behavior, political decision-making, and technological innovation, for example, into the general conceptual scheme of economics. I suspect that Foley is less skeptical than I am about the success of such efforts.

On the whole, Foley is an admirer of the Marxian intellectual enterprise, though not uncritically. He is certainly aware that many of Marx’s confident predictions about the long-run trajectory of capitalist economies have been dead wrong. He is also a critic of mainstream—“neoclassical”—economics, but with some real appreciation of what it can do. The picture of how the prices and quantities of goods are determined by supply and demand in interrelated markets, as worked out by Alfred Marshall and others toward the end of the nineteenth century, is a workable and flexible apparatus that has been developed in many directions, especially for markets that are less than fully competitive. Most amateurs who attack neoclassical economics and its offshoots have no grasp of the thing they are attacking. The mainstream does a better job of self-criticism than the critics. Duncan Foley (who, I should say, is a friend and former colleague of mine) is in a different class. He understands the assumptions, methods, and results of mainstream economics as well as anyone.

He does, however, make some decisions that are surprising and puzzling. Why, for instance, should a 228-page exposition of what the educated reader should know about economics contain a sixty-eight-page chapter on Marx and a single twenty-three-page chapter (entitled “On the Margins”) on a century and a quarter of mainstream economics? After all, the educated reader will come across neoclassical economics in contemporary discussions of many concrete issues, such as the level of wages or the setting of oil prices. To begin to understand Foley’s aim, and to get on to “Adam’s Fallacy”—Foley’s phrase for Smith’s central assertion that “capitalism transforms selfishness into its opposite: regard and service for others”—it is useful to come back to the labor theory of value and the dichotomy between value and price.

Everyday life is about prices, not values. The daily decisions of buyers, sellers, workers, employers, investors, trade unionists, and other market participants depend on current and expected prices. If labor values were good forecasters of future prices or price trends, they would have an important function; but they are not. For example, a product that may require a great deal of labor may actually cost far less than a similar product that requires comparatively little labor, but instead uses more capital and raw materials. Karl Marx realized that there was a problem here, and he improvised a complicated story about the “transformation of value into price.” This turns out to be either mystification or bad algebra. Foley’s long chapter mentions the rather Talmudic literature on this subject and passes on. So what is the labor theory of value for, and why should the educated reader care?

I think the labor theory of value is not a part of the economics of everyday life at all; it is a part of what Foley calls economic theology. It is not intended to help explain what happens in the world; it is intended to crystallize and support an attitude toward capitalism as a social form. It is, in short, the basis for an argument that capitalism rests on the exploitation of labor.

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