Wanted: A theory of wealth

Neoclassical economics can't really explain where income and wealth creation come from. To find out, we must go back to the laws of physics.

The question "where does income come from?" was at the core of pre-neoclassical theories of economics. It was phrased differently, as the question of the "theory of value”, but the essence of the question was "what is the source of the physical surplus of goods that are produced each year?”

The issue disappeared in modern neoclassical economics because the word 'value' was reduced simply to a question of relative prices – which is why I titled one chapter in my book Debunking Economics "The Price of Everything and the Value of Nothing”. But the topic is far more than just a question of how relative prices are set. At its heart, this is an existential question: humanity produces not merely enough to stay alive from year to year, but a surplus above needs that (at least for some) results in enormous opulence.

Of course, one simple answer is that there isn’t a surplus – some are driven below subsistence, and their suffering becomes the source of the excessive incomes of the minority. But while there are indeed people who starve to death each year given the current distribution of income, that answer doesn’t survive serious scrutiny as an aggregate explanation – and I won’t waste time examining it further here.

The first coherent answer on how society can generate a surplus – a physical excess of outputs over inputs, so that humanity lives above mere subsistence (though income might be unfairly distributed) – came from the physiocratic school of economics, which originated in France before the publication of Adam Smith’s Wealth of Nations in 1776. They argued that the source of the surplus is the sun. The free energy raining down on the planet was the source of the surplus of outputs over inputs. This free energy was harvested by agriculture, and then distributed through the rest of society by manufacturing, taxation, etc.

They were so adamant that agriculture was the only source of surplus that in Tableau Economique, the model that provided the foundation for physiocratic economics, its author, Francois Quesnay, described farmers as "the productive class” and manufacturers (both workers and capitalists) as "the sterile class”. All manufacturing did, Quesnay asserted, was transform the surplus generated in agriculture into other forms.

Adam Smith, a Scott who went to France to study under the physiocrats, disagreed with them about the source of surplus. Reflecting the industrial nature of British industry at the time, Smith could not accept that labour in manufacturing was "sterile”. He instead proposed that surplus arose from the division of labour that large-scale industrialisation allowed. His famous example of a pin factory is worth citing at length:

"A workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day… But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands… I have seen a small manufactory of this kind where ten men only were employed … make among them … upwards of forty-eight thousand pins in a day."

Manufacturing therefore was productive, Smith asserted – though Wealth of Nations still allowed that agriculture was more productive than manufacturing because:

"No equal capital puts into motion a greater quantity of productive labour than that of the farmer. Not only his labouring servants, but his labouring cattle, are productive labourers.”

That was too much for Marx, who refined Smith focus on labour to say that labour alone was the source of surplus. I’ll have more to say about Marx in future posts, but his initial – not his final – argument was that surplus came from labour and there was a gap between the cost of labour and its productivity. This led to what became known as the "transformation problem”, which locked a century of Marxists into a futile attempt to reconcile Marx’s arguments with linear algebra.

In the 20th century, the ascendant neoclassical theory argued that you couldn’t favour one input over the other: both labour and capital contributed to output, and could be smoothly substituted for each other in what they called a "production function”.

The problem for neoclassicals was that, just as Marx’s argument created a conundrum for Marxists, so did the core neoclassical model – developed by Robert Solow – for neoclassicals. Changes in the amount of labour and capital in Solow’s model accounted for less than 50 per cent of recorded growth: the gap, which became known as "Solow’s Residual”, was attributed to technological change – for which neoclassical economics had no theory.

If this looks like a mess to you, you’re right: economic theory should be able to answer this question, but the best it has managed is to get it less than half right.

The solution, ironically, is to return to the 19th century – though not to its economists but to its physicists, and in particular Ludwig Boltzmann, who developed what is now called the second Law of Thermodynamics. These laws, unlike those of economics which are violated more often than observed (anyone for the Law of One Price, or the Law of Demand?), cannot be broken – and production, which is a physical activity, must therefore obey them.

The four laws of thermodynamics are neatly summarised in a simple ditty:

0th: You must play the game
1st: You can’t win
2nd: You can’t break even
3rd: You can’t leave the game

The zeroth law concerns the dynamic tendency of energy to dissipate: if two connected vessels differ in energy, energy will flow from the high energy vessel to the low one. Hence, "you must play the game”.

The first is the Law of Conservation: new energy and matter cannot be created. Hence, "you can’t win”.

The second is the real catch: the degree of order tends to diminish over time. Connect one vessel full of air to another with a complete vacuum, and over time the pressures will equalise. The equalised arrangement is less structured than the starting point. At the starting point, useful energy can be extracted by putting a fan between the two vessels; at the end, there’s still energy in the system, but no useful work can be extracted. Hence "you can’t break even” – the energy in a system will become less useful over time.

The third law says that you can escape the consequences of the second law if and only if you can dump the waste heat from a working engine into a vessel whose temperature is absolute zero – minus 273 degrees Celsius. Unfortunately, there is no such vessel – hence "You can’t leave the game”.

How does production – and the generation of a physical surplus – fit into this?

Production appears to defy these laws. Each year we start with a given stock of produced outputs, which become inputs to production, and (except during recessions) we end up with a larger stock of more elaborately transformed outputs. Yet the second law can’t be defied, any more than one can defy the law of gravity. So production must cause an aggregate increase in disorder over time.

The only way to reconcile production with the second law is that production involves a localised reduction in disorder in the goods and services we generate, which is more than countered by an increase in disorder via the waste outputs from production. Figure one gives a visual representation of this process – and 'free' energy, energy not produced by humans but nascent in the universe itself – plays a crucial role.

Figure 1: A visual representation of production and entropy

image

This free energy can take many forms. It can be solar radiation, as indicated in figure one, but it can also be stored energy in fossil fuels, nuclear energy in transuranic elements, even nascent nuclear fusion energy in deuterium and tritium. Without this energy, production – and life itself – would be impossible.

It therefore turns out that the most realistic economic theory of "where does income come from?” was the first: that developed by the physiocrats. Their mistake was to identify the sun as the only source of free energy, and to believe that only agriculture could exploit it free energy. But they were the best: subsequent economic arguments, from Smith through Marx to Solow, took us further away from the proper foundation for a "Theory of Value”.

Econophysicists are taking us back to that foundation now, with the most well thought out work to date being done by Robert Ayres and his colleagues. Their empirically derived model, which treats energy as the key source of production and labour and capital as adjuncts to the exploitation of free energy, adds energy as an additional independent input to production. They call it an "energy-dependent Cobb–Douglas function”:

image

Whereas Solow’s model (which has labour and capital as independent inputs, but not energy) misses over half the actual growth, Ayres’s model’s fit to the observed growth in economic output in the US from 1960-2999 has an R-squared of 0.999.

Economics has to start from an explanation of where income comes from: a Theory of Value is inevitable. Since we live in a physical universe, this theory must be physical in nature, and the second law is the ultimate physical rule. In my future economic modelling, I’ll be revising my production equations to be consistent with Ayres’s work.

Steve Keen is a professor of economics and finance at the University of Western Sydney and author of Debtwatch and Debunking Economics.