Economics 5: a market economy

by George Hatjoullis

Modern economic theory places the market economy at centre stage. The central principle is that individuals acting in their own self-interest lead to a socially optimal outcome (which begs a huge question: what is socially optimal?). We have already seen this is not exactly the case. We have introduced public goods and externalities and demonstrated that these are not adequately accounted for by markets. We have demonstrated (or at least tried to demonstrate) that markets can fail and this may require government intervention through fiscal policy to keep the economy from operating well below capacity. Examples of financial market failure are scattered throughout the Gestaltz blogs and it has been illustrated that such failure can have catastrophic effects. We have also demonstrated that governments can introduce moral hazard into the market mechanism and this may distort the economic system and create new problems. One major problem, insufficient aggregate demand relative to supply (discussed in economics 4), actually arises out of the main strength of the market system. Maybe Marx’s dialectic had some validity.

The market system is built on fear and greed; fear of failure and an insatiable appetite for money wealth. It is fear that keeps greed in check but can also drive the appetite. The owners of the means of production risk their money wealth in order to gain more money wealth. The appetite for wealth accumulation seems unlimited. This is because in the market system it is how we keep score. There are other values but wealth accumulation trumps all. This emotion of greed drives us to take chances and innovate. It makes us sensitive to what people want. [It also drives us to manipulate what people want but that is another issue]. The result is investment and technological innovation. The market system is productive.

Investment and productivity growth increase potential GDP. However, it does not necessarily increase employment. Moreover, it changes the nature of employment and the necessary skills. The market system is a brutal process. Failure and redundancy of skills can leave people destitute and destitute people do not have money to spend. Herein lies the logical contradiction of the market system; the need to realise profit.

Lower input costs, such as wages, increase the profit margin but deprive individuals of the capacity to buy (It is interesting to read in the press of late that Abeconomics in Japan may fail unless wages increase). Profit is not profit unless it is realised and this requires sales. The previous four lessons have identified the fact that, in aggregate, the market system does not automatically create enough demand to account for all output so potential GDP may not be reached. Until recently the state took a hand and basically underwrote the aggregate demand. The problem is, as was noted, this just encourages the owners of the means of production to forge ahead with growth and productivity changes, especially if there are no labour market impediments (such unions and strikes and expensive employment laws). In effect, the owners of the means of production have been allowed to expand potential GDP and stake a claim to a bigger share of GDP through a government commitment to ensure that they can realise this claim in the form of monetary assets. The government has committed to provide monetary claims, in the form of government debt, in exchange for the GDP that individuals are unwilling and/or unable to buy. So how does this work?

The government spends money in many ways. It provides public goods or at least organises the provision. It also invests in infrastructure (which of course increases potential GDP). Finally, it redistributes a lot of GDP. It taxes everyone disproportionately and then gives money to individuals disproportionately. People without a job get something to live on. It also funds care for the sick and old. There is plenty of GDP to go around (it would be unsold if the state did not intervene) so why is there so much angst about a pension crisis, unaffordable welfare benefits, an expensive NHS and education system? The problem is the distribution. The owners of the means of production would not be so keen to invest and create the GDP if they thought ex ante (before the event) the state was going to take large piece of the growing cake from them. There is a limit to how high taxation can go without killing the goose in a market system. What about the state just borrowing?

Borrowing of course just shifts the taxation problem to future generations. Assume that instead of taxing the owners of the means of production (and thus discouraging them from growing the cake) and then redistributing GDP to the have-nots, the state just borrows. From whom does it borrow? It borrows by and large from the owners of the means of production. In effect it is borrowing current GDP and promising to pay back more future GDP to the owners of the means of production. This is not GDP redistribution but rather shifting the problem into the future. The owners of the means of production are happy today because they have exchanged their claim on GDP for a monetary asset but their future claim on GDP has merely been increased as they own the debt. The state will be accumulating a growing debt as a % of GDP. This is an unsustainable situation. The only way out is to tax everyone to clear the debt or simply renege on the debt.

One of the interesting aspects of this way of looking at this issue is that it emphasizes that the problem will arise in productive economies with rapid investment as well as unproductive economies. The productive economies often seem immune because they can export the GDP and acquire claims on other nation states. A global debt problem will eventually emerge (sound familiar). Unproductive economies often end up in the same place because the state borrows to maintain unsustainable living standards and usually acquires GDP abroad in exchange for debt. The advent of international trade seems to make some economies more successful at dealing with this ‘excessive productivity’ problem but in reality the problem is just distributed spatially (to other countries) rather than intertemporally (to domestic future generations). The fundamental problem remains on a global basis. The market system is productive but generates an uneven income distribution. This raises problems of monetary realisation of this productivity by those that are generating it and have a claim on the resulting GDP. Attempts by the state to resolve this issue through borrowing just move the problem spatially and intertemporally. The solution is for the state to redistribute income without adversely affecting this productivity. So far this solution has proved elusive.

Any student of modern economics should recognise that the basic assumption implicit and sometimes explicit in economic theory is that income distribution is independent of the productive potential. In Welfare Economics students are introduced to the idea of Pareto efficiency. This principle states that an economic change is worthwhile if the gainers could compensate the losers. There is no requirement that gainers actually compensate the losers or discussion of whether the need to compensate might affect the willingness of the agents to effect the change. Optimal output schemes are defined where independent production schedules are tangential to independent social welfare schedules. But they are not independent. In a market system output and distribution of output are necessarily dependent and in a  way that is not properly understood. The size of the cake is not independent of how it is distributed. Much of the confusion in modern economics arises out of the refusal to acknowledge this fact. Yet it is the logical implication of a system driven by individual fear and greed.

To recap:

1. Modern economics is about market systems and these systems are driven by individual fear and greed.

2. Market systems are productive but necessarily lead to uneven income distribution. This inequality seems linked to the degree of productivity of the economy.

3. Claims on GDP by owners of the means of production need to be realised (sold for) as money if the productive process is to continue. There is a logical contradiction in that greater profit may reduce the ability of the private sector to enable monetary realisation of claims on GDP by the owners of the means of production.

4. The state can underwrite aggregate demand but only by shifting the problem forward in time through borrowing. Internationally trade allows productive nations to shift the problem abroad in exchange for claims on overseas GDP. Global debt claims will be growing.

5. Ultimately, the debt can only be cleared through taxation or default.

6. The problem arises because of the ignored link between the size of the cake and the distribution of the cake in a market system. This is the fundamental contradiction within market systems.

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