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.

The idea that the worker is entitled to the whole product of his or her labor is an old one. Marx sees that if workers actually got the whole product, they might well consume it all, and society would stagnate. If instead they chose to save and invest some of it in exchange for a reward, they would have become part-time capitalists. So Marx decomposes the sales revenue of any enterprise into three parts: the cost of purchased inputs, the wage bill, and the rest. The rest he calls “surplus value,” and it is the existence of surplus value that constitutes exploitation. (Mainstream economics has a different definition: if employers have some monopoly power in labor markets and can thus pay lower wages than active competition would establish, workers are said to be exploited. Who would storm the Winter Palace or transform a whole society to get rid of a byproduct of monopolistic power?)

So the labor theory of value paints a picture in fundamentally moral terms. Labor is the “ultimate” source of “value,” whatever that may mean. The social institutions of capitalism—private ownership and control of the means of production, wage labor, freedom of contract, and so on—are devices to facilitate the extraction of surplus value from labor and its appropriation by a class of capitalists. You learn from this story how to feel about capitalism, not how to predict the price of a bottle of beer.

A conservative wing of mainstream economics paints a slightly different picture. A capitalist economy consists of a collection of free and independent families and individuals, each with his or her own tastes for present and future goods, hard work, leisure, risk-taking, travel, calculating, and so on. Some of those individuals are stronger or cleverer or more artistic than others, and some start off life richer than others, as the result of the efforts of ancestors much like themselves, secured by the protection of property rights. The human propensity to bargain and barter, along with the enormous advantages of efficiency that result from the division of labor and the benefits of coordinated large-scale production, induces them to contract freely with one another to their mutual advantage. Any contract entered into voluntarily must, after all, according to this reasoning, benefit both parties to it. The outcome is the great wealth now enjoyed by all. Attempts by a democratic government to modify this process in the interest of equity or some other soft-hearted goal such as price controls or state-subsidized pensions can only limit its efficiency and very likely make things worse for most people. This set of half-truths is obviously intended to evoke a different feeling about capitalism.

Economic theology masquerading as economics is not anyone’s exclusive property, right or left. Foley is right to insist on that, and it is a useful lesson for educated general readers. But relegating modern mainstream economics to the “margins” is not a favor to his audience because they are deprived of some interesting intellectual machinery that can help them to understand the economics of everyday life. The allocation of fifty pages instead of twenty-three would have given him the opportunity to sketch a validly agnostic reading of some modern economic theory. Instead one finds a casual brush-off, often so casual as to be a misleading distortion.

I will mention one minor example, because it points to a bad habit in mainstream economics that bugs me even more than it does Foley. He remarks, quite correctly, that the mainstream (“marginalist”) project of tracking equilibrium prices and quantities is intrinsically complex and difficult because the buyers and sellers (“agents”) in an economy differ substantially in their interests, tastes, capacities, information, and social positions. Foley writes:

One short-cut, which neoclassical economists frequently take, is to assume that all the individuals in society are exactly alike, so that they can be reduced to a “representative agent,” and then to work out how the representative agent would allocate the existing stock of commodities, and what marginal utilities (whose ratios will be interpreted as market prices) will result.

He then points out that this device is very likely to give wrong answers (and, he might have added, more emollient, Panglossian answers).

This is fine as far as Foley goes, but it does not go very far; I think it is basically uninformative to a non-specialist. It would have taken only a couple of pages to explain that the representative-agent device is far from universal in mainstream economics; it appears mainly in a few sub-areas of the discipline, but one of these is important. The representative-agent device has been adopted by a significant, perhaps dominant, school of thought known as real business cycle theory, and it is applied to a problem of everyday life where it can do a lot of damage: the theory of those irregularly alternating states of affairs we call prosperity and recessions. The representative-agent device, by simply assuming away the more or less obvious differences in desires, expectations, and beliefs among groups of consumers, investors, workers, and business firms, manages to convert the business cycle from a (large or small) pathology of the economic system into a sort of optimal adaptation to unforeseeable disturbances. Thus, a recession is seen as the “rational,” even inevitable, market response to an unforeseen event, not a possibly preventable reaction to excessive capital investment or financial speculation. Here and elsewhere, Foley misses an opportunity to teach useful lessons about both economic theology and economic analysis.

With this background, we can turn to the major theme of Adam’s Fallacy. (The Adam in question is Smith, of course, but the reminder of the First Man is surely intended.) Here is Foley’s first extended statement of what he means:

For me the fallacy lies in the idea that it is possible to separate an economic sphere of life, in which the pursuit of self-interest is guided by objective laws to a socially beneficent outcome, from the rest of social life in which the pursuit of self-interest is morally problematic and has to be weighed against other ends. This separation of an economic sphere, with its presumed specific principles of organization, from the much messier, less determinate, and morally more problematic problems of politics, social conflict and values is the foundation of political economy and economics as an intellectual discipline.

Elsewhere in the book there are many references to Adam’s Fallacy in specific contexts, some of which do not seem to me to fit the basic definition. “The moral fallacy of Smith’s position,” writes Foley, “is that it urges us to accept direct and concrete evil in order that indirect and abstract good may come of it.” But is this a fallacy? Consider one of Foley’s examples:

From Malthus’s perspective, charity to the poor was self-defeating or, even worse, exacerbated the problem of poverty: charity or the dole allows workers to reproduce even when they have no employment. Thus subsidizing the poor pushes down the wage and standard of living at which population stabilizes…. This kind of reasoning is characteristic of Adam’s Fallacy. Its method lies in contrasting the immediate effects of action (charity relieving the suffering of the poor) with indirect, systemic effects (charity expanding the population and lowering the standard of living of the poor). Its burden is the moral necessity of resisting moral impulse….

Now Malthus may have been wrong. Certainly no one in Britain today would think of appealing to the Iron Law of Wages, which holds that wages will be driven down to subsistence levels. But if Malthus was right in eighteenth-century Britain or in some poor country now, then I do not see that his argument involves any “separation” of an objective sphere of economics from a broader moral sphere. He is claiming that, in this case, the pursuit of short-run moral benefits (money for charity) will, through the working-out of certain empirically valid patterns of human behavior (Foley calls them objective laws), result in long-run moral costs that outweigh the sought-for benefits. If your oncologist tells you that this course of chemotherapy will be exceedingly painful but will lead to an enduring improvement in quality of life, you hope she is right, but you do not suspect a fallacious separation of an objective medical sphere from a broader moral sphere. Similarly, refusing charity to the poor may be painful for them in the short run but may have broad beneficial effects over time. Of course, the modern successors of Malthus, who have sometimes argued that the relief of poverty through public assistance actually creates and prolongs poverty, may drastically overstate the case.

The reach of Adam’s Fallacy may thus be a little less than Duncan Foley suggests. But the original statement of it is interesting and important. Someone like me, who adopts the mechanic’s-eye view of economics, has to deal with it.

Students of economics are indeed taught to make a clear distinction between positive statements (this is how this piece of the world works) and normative statements (some states of the world are better than others). They are taught that no “ought” follows from an “is,” except with the addition of a clearly defined ethical criterion. And then they are taught a very stringent criterion of betterness, devised in the early twentieth century by the Italian economist Vilfredo Pareto: a state of the world A is “Pareto-better,” or more Pareto-efficient, than state of the world B, if and only if every person is better off in his or her own estimation in state A than he or she is in state B.

There are three important things to say about that criterion. First, it is totally individualistic; no person’s well-being can legitimately be traded off against any other person’s. Second, for that very reason, it is almost impossible to satisfy in practice; not many policy moves that are of benefit to many will be costly to no one, and certainly not redistributive moves. Third, for that very reason, there is a temptation to violate the Pareto rule in practice; but it serves the purpose of reminding the violator to be clear about the “welfare criterion” being appealed to.

There is a common, theologically fraught pitfall here. We are all familiar with statutory regulations that are said to “distort” economic decisions, and prevent resources from being allocated to their socially most productive use. Presumably they are enacted for some worthy purpose. Rent control is an example: large rent-controlled apartments may house small families who cannot afford to leave, while larger families pay higher uncontrolled rents for smaller spaces. (Leave aside any effect on new construction.) An end to rent control would allow an increase in “efficiency,” in the precise sense that everyone could be better off: those who gain from decontrol could in principle compensate—perhaps through state-imposed taxes and transfers—those who lose, and have something left over to share around. But that never happens: instead, the rise in rents following decontrol amounts to a transfer of wealth from tenants to landlords. The Pareto criterion is not satisfied in practice. But acolytes of the free market focus on the gain in efficiency and tend to neglect the equity or distributional consequences.

This is, just as Foley says, an illegitimate separation of economic from moral considerations, an example of Adam’s Fallacy. But it is not intrinsic to marginalist or neoclassical economics. In fact the analysis of the effects of abolishing rent control that I just sketched is neoclassical economics. The trouble is that neoclassical economics is amazingly good at teasing out the last detail about efficiency gains and losses, but it has no special tools for analyzing equity considerations. So there is a tendency to marshal “economics” on behalf of free marketeering, knee-deep in Adam’s Fallacy. The remedy, it seems to me, is to show where the applications have gone wrong rather than to abandon the theory in favor of some inferior mode of thinking.

Foley is deeply skeptical about the ability to correct misguided applications of neoclassical economics. “In its sophisticated form,” he writes, “neoclassical economics finesses the question of morality through a version of pragmatism.” But are there really any significant instances where the economic and the moral are so inextricably intertwined that careful analysis and fact-finding cannot succeed in elucidating the issues? The only cases I can think of are those where the economic act itself is felt as immoral: for example, we do not allow the voluntary sale of body organs for transplant. Even so, we mechanics would opt for sticking to those problems—of which there are many—where one can figure out (a) how the system works, and (b) exactly what moral issues are implicated. These might include, for example, the price of oil, the control of pollution, the inequality of wages, the persistence of unemployment, and the necessity of some public investment. Render unto Marshall…

My tentative view is that Adam’s Fallacy is better regarded as a bad habit that certain ways of thinking about economics may encourage, though not necessarily imply. Maybe it should be called Duncan’s Temptation. Infatuation with the remarkable properties of decentralized markets, and with the capacity of modern economic analysis to sort them out, does not provide a free pass to “leave it to the market” regardless of distributional and other ethical considerations.

This conclusion is worth some emphasis. Foley reflects on Adam Smith’s claim that unfettered competitive markets guide the consequences of self-interest to a socially beneficent outcome. Modern students learn that this “beneficence” has to be carefully interpreted. The economy starts with a set of participants, each endowed with a certain bundle of resources, property, and capacities. According to the remarkable “First Theorem of Welfare Economics” (conceived by Kenneth Arrow, among others), a perfect free market system—and months of study go into the precise meaning of “perfect” here—will achieve a Pareto-optimal outcome. No feasible reallocation can make anyone better off without making someone else worse off. That might be described as a certain kind of beneficence. But if the initial endowments of each participant in the economy had been different, a different Pareto-efficient outcome would have come about, and very likely those individuals whose endowments of wealth and skills had been improved would fare better in the outcome. So the free market outcome is no “better” than its starting distribution of wealth. It can be described as socially desirable only if the allocation of initial endowments was socially desirable. The theological free marketeer likes to omit that proviso. A good student should not.

Toward the end of Foley’s short book, there is another short chapter about four maverick early-twentieth-century economists: John Maynard Keynes, Thorstein Veblen (a favorite of mine too), Friedrich Hayek, and Joseph Schumpeter. Keynes is the most important of these, and Foley does well by him, though I would have liked more attention to the uses that mechanics have made of Keynes’s ideas in analyzing the day-to-day operation of the economic system as a whole. This is especially important when there is excess unemployment and idle capacity, and the beautiful neoclassical rules do not apply.

The space available for Veblen is not nearly enough to allow a discussion of the variety of his offbeat insights, but I am glad that Foley included him. He is also good on Hayek, especially at drawing a line between Hayek’s essential contribution about the informational content of decentralized markets and his purely ideological utterances. I was especially delighted to hear that Duncan Foley finds Hayek’s book on business cycles as incomprehensible today as I found it as a student sixty years ago. I am less of an admirer of Schumpeter than most contemporary economists, apparently including Foley. Here, too, I would have liked a little less of Schumpeter’s Capitalism, Socialism, and Democracy, and a little more about his earlier Theory of Economic Development, with its focus on entrepreneurial innovation as the driving force of economic progress. Anyway, the best these short vignettes can do is to induce some readers to go further.

So what would I tell an educated general reader who is looking for a book on economics? Duncan Foley could not fail to have written a book with spark and depth. He has done that, and it ranks right up there with Heilbroner’s classic. Heilbroner has more to say about the political and economic setting in which each of his worldly philosophers emerged; but Foley gets deeper into the analytical content of major schools of thought. Still, Adam’s Fallacy is not the book I would have wished for. That would have been more of a Popular Mechanics: this is what they say about the exchange value of the dollar; this is what they say about the combination of recession and inflation; this is what they say about the estate tax; and this is how they tie these things together. Yet another take will be available next spring when Oxford University Press publishes Partha Dasgupta’s Economics: A Very Short Introduction, which is more about the institutional infrastructure required for a well-functioning market economy. Maybe the best thing to tell the educated general reader now is: you know, you could read two books.


Wrong Values January 11, 2007